Rise by the oil, fall by the oil (Part 1)

We've seen how Ronald Reagan benefited from the drop in oil prices (see "Great in debt") to secure a presidential second term. Margaret Thatcher, his political soul mate, also profited from oil but in a contrasting fashion. It's doubtful whether they were aware how their fortunes had been closely tied to swings in oil prices.

Oil's tentacles go beyond deciding the fates of petro-state politics. Even great leaders of the western world survived on the indulgence of oil. Had Reagan been in Carter's shoes, he would have faced the same travails that had plagued Carter with equally limited options of wriggling out. Reagan avoided the fate of Carter because oil prices were trending downwards towards the end of his first term as a result of falling consumption following the long recession from July 1981 to November 1982. The cause was the high contractionary interest rates imposed by Volcker. To his benefit, oil prices stayed low throughout the second term of his administration. This time it was the Saudis who precipitated the price fall by suddenly unleashing output from two million barrels per day (mbpd) to five mbpd.

Reagan's successor George Bush the first might have earned his second term had he not raised taxes and had the Savings and Loan financial institutions not imploded, the implosion itself a consequence of Reagan's deregulation. These two events resulted in a pullback of the money supply growth, effectively scuttling Bush's reelection hopes. The oil price then wasn't a spoiler as its price was still benign except for a short-lived spurt as a result of the first Gulf War.

Thatcher's fortunes however differed. Whereas the US presidents needed cheap oil for economic prosperity, Thatcher depended on expensive oil to sustain Britain which was gradually losing competitiveness on its manufacturing front. Thatcher's predecessor, James Callaghan correctly predicted that the winner of the 1979 election would stay in office for a long time, reaping the benefits of the oil revenues which were about to pour in. He didn't need any clairvoyance as Britain's North Sea oil which had been first discovered in the early 1970s was subject to the usual lead time of 7 to 10 years from discovery to production (see chart above). Thatcher came in at the right time to hold the premiership for more than 11 years.

Now oil has always been subject to great price swings. So were Thatcher's fortunes. The significant drop in oil production and exports in the early 1990s (see left chart) correlated with Thacher's resignation from the premiership on 28 November 1990.

So it appears that Thatcher's great standing rested entirely on oil. How about her economics ideology which initially relied on Milton Friedman's monetarism? She was said to have successfully tamed inflation. Like the oil story, we can set the record straight since most people still think that defeating inflation is a matter of just hiking the interest rates up. Friedman would have recommended restricting the supply of credit rather than manipulating its price, that is, the interest rate, but Friedman's approach would have caused a sudden shock to the credit supply that all developed economies have now abandoned it.

Thatcher, although a novice at economics, was a consummate politician, ever willing to ditch any economic ideologies at the first sign of voters' discontent, particularly nearing an election year. Unfortunately, the British public had to become guinea pigs for her Friedman-influenced monetarist ideas. To suppress inflation, she started off not only by raising interest rates to 17% in 1980 but also drastically reducing public spending in her first budget. The impact was immediate. By the following year manufacturing production fell by 14% and unemployment rose to 2.7 million. British manufacturing capacity shrunk by 25% in 1979-81. Not only that, influenced by Friedman's Chicago liberalism doctrine, she also abolished the controls on capital movement. This is one measure that all countries will come to regret 30 years later with the onset of the Grand Depression.

The austerity measures were driving Britain into bankruptcy. Only the North Sea oil was keeping Britain solvent. Soon Thatcher became the most unpopular Prime Minister in British history. Unemployment hit the Black minorities disproportionately, eventually boiling over into the summer 1981 race riots in several British cities. Thatcher quickly reversed course by ditching Friedman's monetarism temporarily. It is sad to find that politicians, including Britain's very own David Cameron, still believe in austerity measures when history has proven them to be a complete failure.

By autumn 1981, Thatcher started cutting interest rates. In the following year's budget, Thatcher increased public expenditure. With the high number of the unemployed, it was not surprising that inflation remained low. Oil prices were also moving downwards. More importantly, the British economy was increasing its money supply (see chart below from McKinsey). It should also be noted that the previous British governments since the World War II had to contend with high public sector debt. So they resorted to inflation to bring the share of public debt down to manageable level. Thatcher benefited greatly from her predecessors' efforts, enabling her to start pumping credit again, though this time using households and financial institutions to undertake the borrowings. This recovery and the euphoria from the Falklands war victory enabled Thatcher to retain her premiership in the 1983 election.

The impact of the inflation especially in the 1970s helped to whittle down the real value of debt. As seen in the chart below (again from McKinsey), debt or credit has always been on the increase. Any political leaders thinking of crimping the total credit growth are dangerously courting a total social breakdown. Only inflation could ameliorate a debt growth. Consequently, the inexorable rise in UK's total real debt level beginning from the Thatcher's administration can be attributed not in a small way to the low inflation conditions prevailing since then.

Since Thatcher's story has many interesting lessons for our bumbling EU politicians, we'll continue the second part of the story with the conditions leading to her downfall.

Great in debt

It is said that Margaret Thatcher and Ronald Reagan were the two great leaders of the western world in the 1980s, instrumental in ending the Cold War and ushering in a new era of small government, low taxes, free trade, weak union, prosperity and freedom. With the current palpable lack of leadership in the major economies, the public is yearning for the good old days of Reagan and Thatcher.

We don't want to revisit the legacy of both leaders; that would be the job of historians. Indeed they were truly admirable. But were there to be a leader of similar ability, could he or she reach the great heights of global stature especially in these trying times? Or was there something else about Reagan and Thatcher that has yet to be made known to us, the gullible public?

With the benefit of hindsight and a vast treasure trove of information on the web, we can now reexamine the reasons behind their prominence from the perspective of the 4C (see "Reality in 4C"). You should have been aware by now that Reagan secured his second term by paying homage to the credit market. But let's get into the details to debunk the conventional wisdom surrounding Reagan first, to be followed by Thatcher in a future post.

We begin with the tax and spending cuts, two issues frequently cited by the Republicans to justify their calls for similar action by Obama. When Reagan came into office in 1981, he reduced the top marginal tax rate from 70% to 50%, and federal spending by almost 5% of the federal budget. However this step could only last one year as coupled with Volcker's high fed funds rate that topped 19%, the economy was plunged into a recession (see left chart from The New York Times). The fall in inflation rate following Volcker's tight money policy accentuated the fall in the tax intake. So Reagan had to reinstate the tax revenue in 1982 not by reversing course but by transferring the burden onto businesses. Still, his tax cuts were much more than the increases; by the end of his administration the top marginal rate was further reduced to 28%.

The result of the tax cuts was reflected in the ballooning federal deficit, tripling from US$900 billion to $2.7 trillion by the end of his administration (blue column on the left chart). However this deficit actually boosted the economy. It supplied the spending and liquidity that uplifted the incomes of households, businesses and foreign nations. In turn the businesses and households took on higher borrowings of their own, resulting in a spike of total US debt that started from the end of Reagan's first term.

Now, two questions remain a puzzle to most observers of the Reagan administration. First, can't we continue the borrowing binge by all sectors that brought prosperity not only to the US but also to the whole world? Second, why was the inflation subdued when in fact the money supply as reflected in the debt increase during his second term was skyrocketing? Nobody has satisfactorily addressed these issues. Our attempt will demonstrate that Reagan came into office at the most propitious time. Because of that, his mistakes, which would have been calamitous to any other president, were glossed over.

He gained much from the cautious policies of his predecessors. Not only were they conservative with deficit spending but the inflationary conditions that had characterised their presidencies reduced the relative level of the federal debt. For example, Carter increased the federal debt by about 30% but because of the inflationary condition, the debt/GDP ratio actually decreased by 3.3%. Reagan's two terms however marked a new era of debt financing, not only by the government but also by the other sectors: businesses and households. Reagan took advantage of the depressed borrowings of the earlier years to let rip the borrowing and spending spree.

Also, unlike Nixon, Ford and Carter, Reagan didn't have to endure periods of high inflation, commonly known as stagflation because of the stagnating GDP. Milton Friedman used to remark, erroneously in fact, "Inflation is always and everywhere a monetary phenomenon." It should have been a 4C phenomenon instead of only a monetary phenomenon. The other important factor is capacity in which oil plays a very significant role as the driver of virtually all economic activities.

Remember that oil prices started to experience wild swings following the 1973 OPEC oil embargo. In fact, the sudden jump in prices wasn't totally unexpected had the buyers observed the declining spare capacity leading to the embargo (see "Oiled for Turmoil"). But as new oil fields took at least 7 to 10 years from initial exploration to production, it wasn't until the early 1980s that these fields managed to boost the spare capacity. However the 1979 Iranian Revolution followed by the Iran-Iraq War in the following year further scuttled oil production leaving the Carter administration wondering why his increased spending didn't translate into higher economic growth instead of higher inflation.

Only in 1985 did the prices drop to US$26 per barrel and by the following year to as low as US$11. Until the end of Reagan's second term the prices remained favourable, hovering around US$20. So Reagan could have the cake and eat it too, his spending going straight into the consumers' pockets instead of the oil producers'. Production capacity could increase to take care of the spending when previously any increase was constrained by higher input costs.

These two factors explain why no one else can repeat Reagan's feat and why there is so much yearning for Reagan's leadership. Although oil prices will likely go down as vast new fields in North Dakota, Colorado, North Sea, Colombia and Brazil's coastal waters come onstream in the next couple of years, the debt could no longer be increased. It has reached the peak of the S-curve and the only way forward is down. Those who want to spend no longer have the income to afford the debt while those who have the means have no use of further borrowings.

Poor Obama, intelligence alone is not enough to guarantee good leadership. More important is the external environment which in these troubled times can do far more to make or break a leader.

The errors of the neo-Keynesians

The importance of observing events cannot be emphasized enough as demonstrated by the erroneous diagnoses and prognoses of the global economy by the self-proclaimed experts. So let's tease out the reasons behind their errors which typically stem from incorrect observations.

For this post, we'll deal with the neo-Keynesians since they have quite an influence on the economic thinking of most governments, especially those bent to the left. The neo-Keynesians seek to fuse the thoughts of John M. Keynes (1883-1946) with those of classical economists. They have introduced mathematical models, something which Keynes never used, to provide a semblance of rigorous veracity. As always the case, the legitimacy of models depend on the assumptions and in this the neo-Keynesians fall far short of reality.

The neo-Keynesians  argue that government intervention is needed for continual economic growth as capitalism, left to its own devices, can dislocate itself by going unnecessarily to extremes. Therefore the guiding hand of the state is needed to ensure full employment and price stability. Whereas Keynes counselled intervention during a crisis, the neo-Keynesians support intervention on a continuing basis. Keynes also stated that an economy's output in the short run was determined by the aggregate demand, that is, the total spending of households, businesses and government. So Keynes's advice for the government to spend heavily during the Great Depression of the 1930s was right but it was only right for that time and under the conditions prevailing then.

It's easy to see where the neo-Keynesians have misunderstood Keynes. They have placed demand as the solution to recessions and economic slowdowns for all times. Now if we weigh this against the 4C framework, it is obvious that the neo-Keynesians have ignored both Capacity and Communication, and placed little importance on Currency. Their obsession has always been with Consumption. Till today, Paul Krugman, the popular public face of the neo-Keynesians, stubbornly insists on major government deficit spending to stave off the depression, not realising that such a move only buys time. It's a counter-measure, not a solution since there is no solution.

Now let's tackle their theoretical underpinning, that is, the IS-LM (Investment Saving - Liquidity Preference Money Supply) model (see left charts from The Economist). This model works only in a closed economy and as low cost producers started to compete with American goods in the 1970s, the model began to give way.

The model has two curves, the IS and the LM. The IS charts the different combinations of output and  interest rates at which demand equals supply (or saving equals investment). It marks the real (goods and services production) part of the economy and therefore used as the basis for fiscal policy. It is negatively sloped because as interest rate goes down, output (synonymous with income or demand) increases. The neo-Keynesians believe government can shift this curve to the left (by reducing spending) or the right (by increasing spending), thus reducing or increasing income. With an open economy, a shift to the right may not result in increased income if the income is siphoned off by the foreigners. The other failing is that with increasing technology use, the income is not shared by all as a few producers become very efficient leaving many others without jobs and income.

The LM curve on the other hand charts the different combinations of output and interest rates at which the demand for non-interest bearing money equals its supply. It is positively sloped because as output increases, the demand for holding money increases thus pushing up interest rate. It forms the basis for monetary policy. The government, it is thought by the neo-Keynesians, can shift this curve to the right (by printing money) or the left (by issuing bonds to mop up the money). The intersection between the IS and LM curves represent the equilibrium point for goods production and money holding. In reality, it's doubtful whether there is such a state.

The events post 1973 rendered the IS-LM  irrelevant. As oil prices began to rise after 1973, the recycled petrodollars from the inflating oil prices pushed money supply up through bank lending. The Fed had to jack up the fed funds rate to almost 13 percent in 1974 to suppress inflation. Although inflation did indeed fall briefly to 4.9 percent in 1976, it was achieved at the cost of high unemployment. Energy had become a constraint on capacity as new oil fields, now explored as a result of the high prices, took some time to enter production. Only by the mid 1980s, did oil prices fall. Consequently much of the late 1970s and early 1980s was characterised by high inflation and high unemployment, a phenomenon known as stagflation.

As the neo-Keynesians were baffled by this turn of events, Milton Friedman of the monetarist school came up with his NAIRU (non-accelerating inflation rate of unemployment) which posits that there's a natural rate of unemployment below which inflation will rise.

We can now prove that both schools are wrong. The neo-Keynesians and the monetarists have been using the unemployment rate as the yardstick for measuring capacity utilisation. High unemployment, in the neo-Keynesians' views, reflect high slack capacity and therefore the economy could do with some monetary expansion to increase output with no impact on inflation. However had they studied the 4C's Capacity, they would have realised that capacity is much more than unemployment; energy, materials and technology play a much bigger role. With so much automation in the factory even as far back as the 1970s, labour was no longer a key factor in determining the economy's capacity utilisation. Actually unemployment now has no relations to capacity utilisation as we now have surplus capacity but high unemployment. As for Milton Friedman, his views were always naive but the fact that he could influence so many policymakers to this day is a reflection of the low acumen of those to whom we surrender our fate.