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Inflation Causes Rising Oil Prices, Not The Reverse

Inflation Causes Rising Oil Prices, Not The Reverse

The current debate over whether rising oil prices will lead to higher inflation, repeating the experience of the 1970’s, is an exercise in flawed logic, as the “oil shocks??? of the 1970’s were the effects, rather than the cause, of the high inflation that characterized that decade.

The seeds of the “oil shocks??? of the 1970’s were sown in the 1960‘s, when the Johnson administration’s “guns and butter??? policy caused an overly-accommodative Federal Reserve to monetize the resulting budget deficits, which soared due to excessive spending on “Great Society” programs, the “War on Poverty,” the space race, and Vietnam. The increases in money supply (i.e. inflation) needed to finance such deficits ultimately caused President Nixon to twice devalue the dollar and finally abandon the gold standard completely in 1971.

By 1973, the price of gold had risen to three times what it had been when Lyndon Johnson first took office. Since the dollar had therefore lost two thirds of its value in terms of gold, prices for all goods and services, including oil, needed to adjust upward to reflect the dollar’s loss of purchasing power. As a result, the dollar price of oil tripled by that year as well. With the inflationary fiscal and monetary policies continuing with Presidents Nixon and Carter and Fed Chairmen Burns and Miller, by 1979 the dollar lost another 80% of its value relative to gold, causing the dollar price of oil to triple again.

Early in the Johnson administration, the excess money and credit supplied by the Martin Fed flowed into stocks, which were in the process of ending what had already been a thirteen year bull market (sound familiar?). The Dow Jones Industrial Average doubled between its 1963 low and its 1966 peak. However, after failing to make a new high during the ensuing seven years of sidewise trading, the popular average finally plunged about 40% before bottoming in 1974. Rather than fueling additional stock market gains, the excess money and credit the Fed created migrated from Wall Street to Main Street, producing higher oil and other consumer prices instead.

Since its peak in 2001, the U.S. dollar index has lost about one third of its value. With inflation moving from financial assets to the real economy, as was the case in the 1960’s, oil prices have already doubled and the Dow Jones has traded sideways for almost five years without making a new high. With Greenspan/Bush following the Martin/Johnson “guns and butter??? deficit spending, easy-money playbook, the dollar will continue to lose value, causing oil and other consumer prices to rise further. The main reason that the current CPI does not already reflect a more substantial rise in the general price level is mainly a function of the new way the current index is being calculated.

As it so happens, William McChesney Martin Jr., who chaired the Fed from 1951 until 1970 (the only chairman to have reigned longer than Greenspan), was the original maestro. During his “new era,??? which gave rise to the “nifty fifty,??? the Dow Jones quintupled fifteen years into his nineteen year term. A similar increase occurred during Greenspan’s tenure as well, only Sir Allen accomplished the feat in a mere thirteen years. If the similarities continue, the Dow Jones will bottom near 7,000 in about 2006 with oil trading above $60 per barrel, and will not make a nominal new high until approximately 2014, with oil prices having first topped out close to $175 per barrel a few years earlier. Adjusted for inflation, the Dow will not register a new high until sometime around 2030!

However, since Greenspan’s monetary policy is far more inflationary than was Martin’s, the resulting asset bubbles more spectacular, today’s U.S. fiscal and trade imbalances more excessive, and given that the U.S. is now the world’s biggest debtor as apposed to its largest creditor, the stock market and the economy should be much weaker, and oil and other consumer price increases far greater, than was the case during the 1970’s.

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