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Crude Oil Prices, Monetary Stability and Credit Expansion

Economics / Credit Crisis 2008 Jul 22, 2008 - 07:25 AM GMT

By: Gerard_Jackson

Economics Best Financial Markets Analysis ArticleI would like to say that economic commentary on the present energy situation is an improvement on what has gone on before. As I said, I would like to. The media message is an old one. Whether it be America, Australia or Europe the cry from greens is that rising oil prices are good for us because they conserve oil and speed up alternative energy and transport technologies. So successful has this line of attack been that some so-called free-market commentators have mindlessly parroted it, oblivious to the fact that it flies in the face of economics.


Alan Wood, an economics writer for Rupert Murdoch's Australian , immediately springs to mind. He now warns that current energy prices are "an early portent of the forces that will shape the 21st-century global economy". ( No benefit in leading , The Australian , 2 July 2008). It was the same Alan Wood who some years ago pushed the green line that if politicians raise the excise tax on fuel we could conserve oil giving the market an incentive to develop an alternative. It never occurred to him that he was making technical progress a function of price. Taken to its logical conclusion, the higher the taxes on resources the greater will be the number of inventions and innovations.

What so many commentators fail to grasp is that free markets, not taxes, conserve resources. This is really basic stuff. When the supply of any resource falls its price rises. Eventually the price reaches a point where the cost of producing an additional unit exceeds the demand. This is why we never run out of resources in a free market. If, however, the resource is treated like a free good, as in the case of fish, then complete exhaustion is possible. This is obviously not the case with oil.

At the time that Wood was writing there were no zooming oil prices. If he had been right about oil in the near future this would have been reflected in a continuous rise in real oil prices, something that eluded him. He does of course refer to the situation as it stands today, but once again he is missing the obvious question: why did oil prices suddenly take off?

This point needs further elaboration. An increasing scarcity of oil would cause prices to rise, signalling to consumers and producers that greater conservation is needed. The supply situation for any resource is always revealed by the interplay of supply and demand. The free play of market forces means that one does not need resource taxes to economise on the use of any resource. The market process will always bring about economisation in a way that no politician, green organisation or government agency could ever hope to emulate let alone better.

But let us examine the matter in a little more depth, something our journalists never seem to do. (Is that because it requires a little thought?) Although rising prices directly act to conserve natural resources, including oil, the process does not stop there. Higher prices stimulate conservation and investment in exploration, new technologies and substitutes. Market processes, therefore, expand the supply of resources by discovering and exploiting new reserves and by substituting new materials for old resources.

In short, increasing scarcity reflected in higher prices eventually reverses itself by increasing supply. This is how market processes overcame an emerging energy crisis in eighteenth century England: coal was substituted for wood, quickly expanding the supply of energy. A similar thing happened in the latter half of the nineteenth century when kerosene was substituted for whale oil which had become increasingly expensive as the whale population shrank.

Now it is invariably overlooked that it is always in the interest of the entrepreneur to maximise the present value of his capital assets, which includes natural resources. (Strictly speaking it is the internal rate of return that an entrepreneur will try to maximise). This means that entrepreneurs will try to avoid excessive depletion of their resources because it would reduce the market value of their assets, the present value of which is the present value of an owner's assets is the sum of their discounted future rents.

Market processes tend to bring these rents into equality with the rate of interest. The irony here is that capitalisation now becomes an argument for the privatisation of state owned lands.

Some greens realise what rising prices can do and that's they push energy taxes under the guise of creating cleaner and cheaper alternative energy sources, when their real aim is to slash energy use. But surely you just said that rising costs eventually lead to an increased supply? Yes, but only if market forces are allowed to do the pricing and allocation of resources. Otherwise the effect of so-called resource taxes would be to lower general welfare.

The likes of Wood should have realised that by restricting the use of 'depleting' resources the state would be forcing companies into making excess investments in their stock. This would generate a false market signal to invest in replaceable resources. For example, if the tax on oil were raised high enough demand would fall, directing investment into substitutes of one kind or another. But this would be wasting resources, what the Austrian school of economics calls creating a malinvestments.

The reason should be obvious to anyone with some economic training. If these alternative economic activities were profitable under free-market conditions companies would have already invested in them. That they don't is a clear demonstration that the necessary resources are more valued elsewhere. In simple terms, these investment would not cover their costs and so forcing them into existence lowers total output and raises costs. This is why greens love 'em, the more intelligent ones, that is.

We can see that extending investment in the conservation of oil to the point where the return is lower than the opportunity cost of the investment is truly wasteful. Yet this is what resource taxes would force us to do. Another effect of these taxes is to extend the conservation of resources beyond the point where they become obsolete, a possibility with an oil 'conservation tax.'

In fact, Industrial development would have been greatly retarded if past warnings of the imminent exhaustion of natural resources had have been heeded. At the end of the day, so-called conservation taxes, especially on oil, are a vicious deceit by which living standards for the masses can be lowered by edict under the pretence of preserving the 'quality of life'. (This is why greenies are jumping with joy over energy prices).

So how come the energy markets — especially oil — did not pan out according to economic reasoning? The answer is a very simple one. This line of reasoning assumes monetary stability. A fact that very few commentators are aware of. Once upon a time the majority of economists had no problem in making the link between a booms and surges in the demand for commodities even though they did not agree on the causes of the boom-bust cycle.

Once we factor in credit expansion another explanation for rapidly rising energy prices comes into play. Over the last few years there has been a massive increase in bank credit. This credit fuelled the booms and drove up the global demand for energy. So great was this expansion that surplus bank credit in the form of deposits started to emerge world-wide. Our economic pundits immediately labeled these deposits surplus savings, adding another fallacy to their erroneous views.

It is now beginning to look like the bloom is off the boom (I couldn't resist that) as indicated by rising short-term interest rate futures.

See Dr Frank Shostak's Commodity prices and inflation — is there a connection?

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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