I got an email asking me about the Iranian Oil Bourse, which is causing great excitement among the Peak Oil crowd. Here’s my draft response. Comments appreciated.
“Bourse” is just another word for “exchange”, and the creation of one in Iran is an attempt to capture more of the economic activity associated with international oil markets and also perhaps to exert more control over oil markets.
The US gains directly from the fact that people hold US currency (since it costs almost nothing to print, but can be used by the US government to buy goods and services – this is called “seignorage”) and indirectly in terms of perceived power and influence from the fact that the $US is the dominant world currency. The switch to euros threatens both. However, the total benefits are not that great. The seignorage benefit to the US from overseas holdings of $US is between $15 billion and $50 billion per year, and the United States has many more important sources of power and influence than the $US.
There is a lot of talk, as in the Peak Oil article linked above, about how Saddam’s switch to euros led to the Iraq War. Actually, as the Iran example shows, overt decisions to switch are usually the result of bad relations with the US, not the cause. Still, this is part of a general pattern of incidents, small in themselves, where aggressive US foreign policy is exacerbating conflict over economic issues, and thereby weakening the US economy.
John Quiggin 
How reliable and in terms of public disclosure how efficient and effective would the the Iran Bourse be?
Isn’t it potentially Haram? esp usuary? http://www.islamonline.net/servlet/Satellite?cid=1124781357897&pagename=IslamOnline-English-Hajj_Umra%2FHajjE%2FHajjE
I recall one of the Green’s candidates in Melbourne, Stephen Luntz, using the argument that Saddam’s decision to ditch the Greenback and adopt the Euro was one of the reasons why the Americans invaded Iraq. At the time I thought this was kooky reasoning and still do. Your argument backs this up.
The dominant position that the US dollar has may not benefit the USA much in terms of seignorage and I agree that attributing this as a reason to go to war is very kooky indeed.
In the short term the Iranians are not doing themselves any economic favours. They are making it harder for their trade partners to do business with them by demanding that they use a less liquid currency.
However the manner in which the US dollar is managed according to narrow domestic consumer price responses in the USA and the consequencial impact of these monetary processes on the instability of world prices (commodity prices like oil in particular) means that the cost to the world is more significant than the benefit to the USA.
In terms of fascilitating global trade, maximising global prosperity and avoiding malinvestment we need a common global unit of account (not a single world currency but a common unit of account) that is both universal and stable. We don’t have this at the moment and almost nowhere is it acknowledged or on the table for discussion.
The fact that the US dollar faces competition from the EURO may ensure some inclination towards the global impact of US monetary policy. However the US dollar is still dominant and is unlikely to be otherwise in the medium term.
Malaysia proposed an Islamic response to this instability a few years ago with its proposed Islamic trade block based on the Islamic dinar (4.25 grams of gold) as the basic unit of account. To date this has gone nowhere.
attempting to belittle a point of view by describing it as kooky does your own point of view no favours,
having had the us$ as reserve benefits them greatly, tying it to oil benefits them greatly,
suggesting that america may attack iran or iraq because of related factors may be wrong,
but it is not kooky
actually check out this kook
Price inflation is raising its ugly head, and the NASDAQ bubble– generated by easy money– has burst. The housing bubble likewise created is deflating. Gold prices have doubled, and federal spending is out of sight with zero political will to rein it in. The trade deficit last year was over $728 billion. A $2 trillion war is raging, and plans are being laid to expand the war into Iran and possibly Syria. The only restraining force will be the world’s rejection of the dollar. It’s bound to come and create conditions worse than 1979-1980, which required 21% interest rates to correct. But everything possible will be done to protect the dollar in the meantime. We have a shared interest with those who hold our dollars to keep the whole charade going.
http://www.house.gov/paul/congrec/congrec2006/cr021506.htm
that kook is congressman Ron Paul, who served on the House Banking committee, he was a member of the Gold Commission, he serves on the House of Representatives Financial Services Committee, and the International Relations committee. On the Financial Services Committee, Rep. Paul serves as the vice-chairman of the Oversight and Investigations subcommittee.
he also states
In November 2000 Saddam Hussein demanded Euros for his oil. His arrogance was a threat to the dollar; his lack of any military might was never a threat. I doubt it was the only reason, but it may well have played a significant role in our motivation to wage war. Within a very short period after the military victory, all Iraqi oil sales were carried out in dollars. The Euro was abandoned.
and
In 2001, Venezuela’s ambassador to Russia spoke of Venezuela switching to the Euro for all their oil sales. Within a year there was a coup attempt against Chavez, reportedly with assistance from our CIA.
easy to write off a member of the australian greens, not so easy to write off Ron Paul
The Peak Oil yay team are also the dreaded gold bugs (www.financialsense.com), conspiracists of the first order
A few questions:
1. Does seignorage only include the benefit of people holding cash? Presumably a desire to hold US$ denominated securities also reduces funding costs of US$ denominated debt by increasing demand for it?
2. To what extent is the ‘pricing of oil in US$’ merely nominal? That is, if the dollar falls against the Euro, does the price of oil increase to compensate?
3. What is the mechanism which makes the currency oil is priced in a popular reserve currency?
Sorry Smiths, I am a card-carrying member of the Greens myself but I don’t see why I should refrain from criticising views from my own side when I think they are wrong. I have no problem calling an idea or statement kooky when it clearly is no matter who says it.
If you think PrQ is wrong then present your case.
I think that Ron Paul gets some of the details wrong when it comes to the nature of money. However he is miles ahead of most politicians. He at least knows which questions to ask.
Ron Paul seems to believe that the US constitution is a good idea. The idea that senators should restrain themselves in accordance with the consitution is a really novel idea that should not to be dismissed too quickly.
Ron Paul was also one of the few republicans to have the insight and fortitude to vote against war with Iraq.
The flaw in your argument is pretty easy to detect – the value you assign to “dollar hegemony” ($15-$100 billion/year) was made up out of thin air and is way too low.
More generally, what you are missing in this and your earlier post on this topic is the relationship between the fixed link between dollars and oil and the US trade deficit. It’s a bit puzzling, if you think about it, that the world is willing to trade actual goods for pieces of paper to the tune of 3/4 of a trillion dollars a year. The “kooky” theory is that international demand for dollars is artificially inflated because of the deal Uncle Sam made with the kingdom of Saudi Arabia in 1973 to always value oil in terms of dollars.
Here are some interesting links:
http://ist-socrates.berkeley.edu/~pdscott/iraq.html
http://www.atimes.com/global-econ/DD11Dj01.html
And if you really want to keep up with the “kooky” conspiracy theories, you have to include the fact that the Iranian bourse (march 20) coincides with Uncle Sam’s decision to stop revealing the M3 money supply (march 23).
http://2thewall.blogspot.com/2006/02/war-with-iran-federal-reserve-and-m3.html
I note from Dear Debbie’s blog that she is a conspiracy theory aficionado. Her pet conspiracy theories include one of those 9/11 conspiracy theories that the dedicated can find on the web.
How about you get back to us when your acne has cleared and you have finished your uni degree? (Hell, I’m starting to sound like an old fart!)
The range outlined by John Quiggin (US$15-50 billion) is pretty spot on. The calculation is pretty straight forward.
According to the link below, the US monetary base (ie currency on issue) as at 15 February 2006 is worth US$795,304,000,000.
http://www.federalreserve.gov/releases/h3/Current/h3.htm
If we assume a nominal interest rate of 5% then we get seignorage of about $40 billion.
A lot of this seignorage will come from the people of the USA so the amount coming from the rest of the world will be a lesser figure.
Given that the monetary base is far less than 3/4 of a trillion dollars then it is clear that the world is not trading all those goods for green bits of paper. The world is trading some of these things for tangible US goods and are providing a lot of these goods on credit. In other words it is selling goods on trust that a tangible supply will be provided in the future. It may surprise you to know that most of us rely on this concept of buying and selling on trust throughout our entire lives.
The global importance of the US dollar does not much relate to either its volume or its roles as a medium of exchange. The most important role played by the US dollar in international trade is as a “unit of account”.
Given the institutional structures surrounding the management of the EURO versus the US dollar, I suspect that over time the EURO will become a preferable unit of account or else the US will face a round of monetary reform. Given the views of the new federal reserve chairman on inflation targeting I suspect we will get more of the latter soon.
Steve M, please be nice to visitors.
Deb, if you follow the links, I cited sources for the estimate on seignorage, and they cite extensive research. As Terje’s simple exercise shows, the magnitude must be rougly right.
A separate, though related, issue, and one that we’ve been kicking around here for a long time is why people are willing to buy bonds denominated in US, with quite low interest rates, to finance a current account deficit which is approaching $800 billion a year and seems unsustainable. While oil exporters are part of this, they are less significant than, for example, the People’s Bank of China, which wants to sustain a $US peg for reasons unrelated to oil.
Foreign investors will look at interest rates as well as at the opportunity for capital appreciation due to currency movement. This is why interest rates in Japan could drop to 0% in the 1990s and people still kept lending their yen.
However there is no longer any prospect of further deflation in the USA (unlike the late 1990s) so that the potential for future currency movements is unlikely to fully answer Johns question.
There are geopolitical aspects to Iran’s desire for a euro-denominated oil bourse. Primarily it is to play China and Russia (and to a lesser ectent, Japan) as a hedge against US military action. China (and Japan) and Russia would (my guess) rather buy oil in euros because they do more trade with the EU than the US, so they already have a strong need to be hold euros in their foreign reserve to limit devaluing against such a major trading partner. If China started buying oil in euros it may wish to peg the yuan aganst the euro rather than the greenback. In any case, it’s argument for being big holder of greenbacks would diminish, and we all know what the consequences of Chinese dollar dumping would be. Soooo, US (or Israeli proxy) military action against Iran would be viewed very dimly in Beijing, Moscow, and probably Tokyo. Severe financial punishment could ensue.
The best hope for the US is a pro-American coup in Iran. What are the odds?
Anyway, like Terje says, this wouldn’t be an issue of there was a stable world-wide unit of account.
Prof. Quiggin says: “Deb, if you follow the links, I cited sources for the estimate on seignorage, and they cite extensive research”. I may be missing something, but the only link I found was to your “Dollar v. Euro” post of 25/4/03, in which you refer to (but don’t link) a chap called Lawrence H. Meyer of the US Federal Reserve Board. A Yahoo search found a June 1999 piece he wrote for the Fed. Reserve Board of Minneapolis in which he estimates the value of seignorage at about $US15b. annually. Is this your source? Mr Meyer cites no research in this paper, which is at
http://minneapolisfed.org/pubs/region/99-06/meyer.cfm
Scroll further down, and there’s a link to Portes and Rey, who in turn cite others. You’ll have to chase the references yourself as they’re not hotlinked and the cites aren’t that detailed, but it shouldn’t be too hard if you’re interested.
The conspiracist in me enjoyed Ron Paul’s article. He has surprisingly individual ideas for a Republican. Also good questions from Tom Davies.
Don’t all these issues come down to the $US being the dominant world currency, including China’s peg and thirst for US bonds and lower costs for US debt? Surely any snub to that dominance, such as an Iranian bourse in Euros, would be seen as undermining it?
I’m also not certain that the US would react in proportion to the immediately quantifiable economic outcomes, although I doubt they have the taste for war right now.
I’ve never found the idea of the dollars-euros switch being the only or major cause of the Iraq invasion convincing. However, it always seemed that the motivation was complex, and this would have been one of the things that was considered.
In hindsite something worth $15-50 billion looks trivial compared to the cost of the war, but remember that in 2002 the Whitehouse was maintaining the cost would be vastly lower (was it $100 billion? plus a handful of American lives). In this context something worth say $30 billion would have been a not-insignificant factor when piled on top of reasons such as revenge, gaining access to the oil, the bounty for Halliburton, the popularity boost for war presidents, the possibility of WMDs etc.
Now that everyone knows how expensive these actions are, I can’t see it playing a significant role in relation to Iran.
steve m, i never said i thought PrQ was wrong, read my post,
i think an invasion of a country would need several strongly converging factors to be contemplated,
all i said was that suggesting iran may have increased its chances of being attacked by attacking the dollar through oil is not kooky,
i also think that writing off any theory as a conspiracy theory like peak oil or 911 is counterproductive,
I don’t discount the idea that Iraq and Iran’s nose thumbing at the US factors into our foreign policy decisions. Romans don’t have a lot of time for insubordination, (especially of the high profile sort), and being a Roman, I can vouch for the appeal of making the world in your image. Saying that, neither Iraq nor Iran’s decisions vis a vis oil transactions are going to bear substantially on the fate of the US$. No, we’ve got a central bank and “government sponsored enterprises” for that. So why the fuss? One need only look at the puerile banter going on between the Bush administration and Venezuela to get a sense for how very much more irrational these decision makers are than would the conspiracy theorists- and economists- lead you to believe.
And given all that, it is ironic to note that US$ profligacy, our status as market of last resort for goods, our open doors policy to goods dumping and attendant deindustrialization has led to circumstances under which the petroleum exporters embracing USD have heretofore made out like bandits. They’ve seen their assets in the bank maintain purchasing power while their assets in the ground skyrocket versus finished goods, (via erstwhile benign ‘core’ inflation), all the while maintaining far greater flexibility to invest in non-dollar assets than the Asian economies that facilitated the raw material/finished goods divergence in the first place. Ironically, if Iran, Iraq, Hugo Caesar Chavez and Jacques Chirac had more success in marginalizing the dollar, it would be in far better shape today. Pepsi has coke, God has Satan, but, notwithstanding its raison d’être, the Euro ain’t no John F Kennedy.
I am looking at this through a worldview prism that intends that military actions should be avoided, not used regularly as a foreign policy tool.
What is being discussed here is the very real threat that the USA or its surrogate, Israel will mount some kind of military attack on the people of Iran.
The ‘war’/’action’ has absolutely no legality or legitimacy and Australians should say that being an ally to the profligate global bully is unacceptable and unsustainable for us. We should not have agreed to go into Afghanistan or Iraq either.
It is possible that the threat by Saddam Hussein to switch to Euros contributed to US decision to attack, but then all the other justifications are just as weak.
Prof. Quiggin, I think I have found the Portes and Rey article (1998; NBER Working Paper 6424) to which you indirectly refer in your post. It is very interesting. But the model which Portes and Rey use does not accommodate the situation where a major commodity (oil) can only be traded in one currency. Their model treats the status of the $US as an international currency as mainly affected by securities markets, not trade, because they see the far greater volume of exchange in the securities markets. They make few remarks about trade, but they do say (re: the impact of the then-imminent introduction of the Euro): “Economies of scale in the use of the Euro will induce firms which trade mainly with the EU to start invoicing in Euros (eg. Central and Eastern Europe, Middle East and North Africa), as will many multinational Japanese and US firms. Some imports from the US and Japan will remain exceptions, as will some primary commodities� (pp.11-12). Though Portes and Rey do not specifically say so, I take “some primary commodities� to include oil, especially since the Middle East is mentioned. But Portes and Rey leave these exceptions out of their analysis. And since their analysis is confined to currency exchanges between the US, the EU and Japan I don’t see where oil trade (with Middle Eastern, African, South/Central American and Central Asian countries) could enter. All this seems to indicate that the Portes and Rey estimates of gain to Europe/loss to the US of the Euro’s introduction are likely to be considerably on the low side.
Nor am I sure that the concept of seigniorage captures all the advantages to the US of the US$ unique position. Portes and Rey estimate $5-$10b. annual flow to the US as a result of the US ability to pay low interest on Govt. bonds, plus 0.1% of GNP as a result of foreigners holding currency. They say these flows are of the same order of magnitude (pp.6-7), so I suppose the total annual value to be about $10-$20b. That sounds pretty significant to me, though I take your point about the much greater cost of the war. But they also note that currency hegemony confers: “…the ability to finance balance-of-payments deficits with liabilities denominated in the international money, which other countries will accept without effective limit. This does weaken a constraint on economic policy, although the possible resulting overhang of liquid liabilities may ultimately pose problems [!](p.5)�. There is also: “…the option to eliminate some of that debt with a surprise inflation (p.6)�. These are advantages above and beyond seigniorage. The opportunity cost to other countries of having to hold so much US currency and debt is not mentioned at all.
for my two cents worth on the wars the reasons are almost identical,
iraq –
1. conrol of the oil, either to get it, or to make sure no-one else does
2. break up stong country into weak smaller states so as to reduce threats to israel
3. send message that oil and dollars stay together
4. get imperial ball rolling with easy conquest to start
iran –
1. conrol of the oil and gas, either to get it, or to make sure no-one else does
2. break up stong country so as to reduce threats to israel
3. send message that oil and dollars stay together
4. send message that america is prepared to use tactical nuclear weapons, so watch out
Re Willy Bach,
I think a conventioal military strike against Iran, as we’ve become accustomed to the term, is unlikely, and is very much frowned upon in the Pentagon. The issue is that it would be the first time since WW2 that the US would strike a power who actually has the capability strike them back hard, militarily. Iran has ground lauched anti-ship missles that the US can’t defend against except by getting the hell out of the Persian Gulf, and other cruise missles that it could use against American assets in Iraq. It’s simply not possible for the US to disable all of these before striking at Iran nuclear assets (but you bet they’ve gamed it, a lot). Iran, in case you haven’t looked, is mostly mountainous, which mitigates aginst ground attack too.
So would they risk an uncertain strike against Iran, against the strong likelihood of losing several large ships in the Gulf, having the Gulf sealed at the Straights of Hormuz, giving the Iranian leadership the chance to crack down on large western-sympathetic forces in their own country, and a huge incentive to aid Shia revolt in Irag and northern Saudi Arabia (where most of the oil is)? I don’t think so. Plus, Iran has done deals with China for cheap energy, so immediately the UN Sec. Council is off limits, and there’s a risk of the Chinese putting the boot into the USD (it would hurt the Chinese too, but a lot less than the US). Finally, the Russians would be mad as hell too, and are playing Iran as thorn in the side of the US for all its worth (hey, they sold the Iranians, and China too, the missles!).
But if the US though it could act militarily against Iran, and it fails (it will), and a few thousand dead Americans wind up at the bottom of the Persian Gulf, I imagine there could be a clamouring in the US for a nuclear strike. Could they be that stupid? Think of the damage to the world economy that would flow (just in oil prices alone)? Could it give the neocons a reason to suspend the 2008 elections?
Apologies for sounding like a rabid armchair conspiracist. It’s not my style, but these days in Washington…
>the model which Portes and Rey use does not accommodate the situation where a major commodity (oil) can only be traded in one currency.
But oil can be and is traded in any number of currencies.
For that matter much (most?) of the world’s oil is consumed in the countries in which it is produced meaning its only ever traded in the currencies of those countries.
20 countries have 95% of the worlds proven reserves and production capacity,
i fail to see how its possible that most oil is consumed in the countries in which it is produced
If the USA lost $20 billion in income it might have to extract the wealth from it’s citizens through taxation. That would amount to little more than an extra US dollar per week per US citizen. I doubt that this would cause anybody to loose much sleep at all. I would suggest that the amount is pretty insignificant (just as John Quiggin asserted).
Regards,
Terje.
P.S. But don’t mistake me for some type of friend of government created fiat currencies.
P.P.S. Do you have a weblink to the Portes and Rey article?
Which is why I asked What is the mechanism which makes the currency oil is priced in a popular reserve currency?
Why does the switch to pricing oil in Euros mean that fewer US$ will be held?
Rather than the one causing the other I would suggest that both are caused by a third thing. And that is the high level of liquidity that the US dollar has.
Of course there is some circularity to my argument. The US dollar is in widespread demand because it is liquid. The US dollar is liquid because the demand for it is widespread. However the circularity of the argument does not invalidate the point.
TD: Which is why I asked What is the mechanism which makes the currency oil is priced in a popular reserve currency? Why does the switch to pricing oil in Euros mean that fewer US$ will be held?
This is a central question, I agree. I don’t know the mechanism, but I believe one exists. Otherwise, why would Uncle Sam have cut a deal with the Saudis in 1973 to guarantee the oil-dollar link would stay fixed? And why does Sam go ballistic when oil-producing nations (Iraq, Iran, Venezuela) threaten to break it?
I think I need to do a whole new post on this.
First, I don’t think there is a direct connection between the denominations used in commodity markets and the demand for currency holdings, but I think there is a connection. The more the $US is viewed as the main currency, the more acceptable it will be in cash transactions where the parties can’t or don’t wish to make use of standard financial channels, and the more acceptable it will be as a substitute for domestic currency in various transactions. What this means is that the issuer of a reserve currency can collect seignorage benefits indefinitely, without worrying too much about exchange rate fluctuations and similar.
Second, as Portes and Rey mention, the issuer of a reserve currency can, on a once-off basis, exploit the belief that assets denominated in that currency are “safe”. Arguably this is what the US is doing right now.
“20 countries have 95% of the worlds proven reserves and production capacity,
i fail to see how its possible that most oil is consumed in the countries in which it is produced
1) It takes a fair bit of energy to actually extract the oil. So oil producing countries use energy from oil in the extraction of oil. This will get worse as we move to lower quality oil fields.
2) Oil producing countries are likely to use oil for electricity generation and other non-transport needs as it will be cheap locally. Non-oil producing countries only use oil for transport as it is too expensive to compete with coal, nuclear, hydro etc.
JQuiggin,
“The more the $US is viewed as the main currency, the more acceptable it will be in cash transactions where the parties can’t or don’t wish to make use of standard financial channels, and the more acceptable it will be as a substitute for domestic currency in various transactions. What this means is that the issuer of a reserve currency can collect seignorage benefits indefinitely, without worrying too much about exchange rate fluctuations and similar.”
Fair enough, but clearly the world is already in too deep with the dollar for the denomination of commodity markets to matter much. I’m a creative guy, but am at a loss to conceive of a way that Iran, Iraq and Venezuela could affect that in a meaningful way. Remember: our currency, your problem. And that was before the world collectively decided that the producing goods for the American consumer was the economic panacea.
As far as exploitation goes, I would argue that the biggest beneficiaries of dollar denominated commodity markets have been commodity producers, and that the biggest losers from the US$’s exorbitant privilege has been American society. That feature of the world’s “imbalances” seems to be woefully underreported.
I would disagree with this point. In what way is the current arrangement better for commodity producers than the previous arrangment. Before the US dollar was floating we had Brenton Woods. Under Brenton Woods we achieved stability in global commodity prices allowing commodity producers to plan production with relative ease. A commodity producer could be confident that the price a year from now would be in the ball park of the price today. 1971 changed all that. Now commodity producers need to deal with commodity price volatility (due to frequent flucutations in the value of denominating currencies). They also need to deal with exchange rate risk. Today they are up to their eyeballs in contracts with banks for things like futures and hedges and all the other remedies to global monetary chaos.
Given Australias position in the global economy as a commodity producer we could show some leadership on this issue and adopt a monetary policy in which the value of our currency was managed in terms of some commodity basket. The Australian dollar being one of the more significant global currencies it would at least create a template for others to consider.
The URL of Portes and Rey (1998) “The Emergence of the Euro as an International Currency” (NBER working paper 6424) is
http://www.nber.org/papers/w6424
Terje, my point was that petroleum exporting countries have benefited by the dollar denomination (as opposed to £ or Â¥ denomination) of petroleum transactions mostly for reasons of tractability, and that this could help to explain why transactions are done in dollars in the first place. In other words, it’s a comment about the ’cause’ side of the reserve currency issue, not so much the effect.
To your point about the stability of commodity prices, I don’t see how monetizing commodities resolves the idiosyncratic problem of supply and demand that drive the relative costs of goods, capital, labor, etc. What’s more, backwardation aside, the ability of commodity producers to lock in nominal revenues is simpler now than ever (and now especially given the epidemic of contango futures contract term structures). This is not to say that a commodity linked reserve currency is a bad idea, just that this is not an argument I would advance to support the idea. A rather better one is such a system’s tendency to mitigate governments’ overprinting their currencies a la John Law and Alan Greenspan (even as it introduces its own monetary instabilities- see Triffin’s dilemma).
Firstly a minor point. I suggested that a basket of commodities become the measure of value that monetary policy should use as a target. This is not quite the same as monetizing commodities. End of minor point.
Currently a lot of the instability in commodity prices is due to short run monetary errors. The current focus of monetary policy is on long term nominal price objectives such as consumer prices (which have a long lag process whatever your monetary setting), with interest rates acting as the interum monetary target. This creates unnecessary swings in commodity prices during the short term. A producer then has to guess at which swings reflect a change in fundamentals of supply and demand for the commodity versus which swing represent a change in the value of the currency.
For instance if the price of oil falls US$0.50 tommorow, then does this mean that the world wants less oil or that it wants more dollars? The producers of oil (and the explorers and investors etc) are left to guess.
Monetary instability leads to poor investment choices. This is one of the major arguments against inflation. If monetary instability was not a problem then 25% inflation would not be a problem.
So in summary a change in monetary policy would not change the “idiosyncratic problem of supply and demand that drive the relative costs of goods, capital, labor, etc.”. However it would improve the price signals that people use in order to allocate these scarce resources.
Terje, I agree that as price level instability creates inefficiencies in the real economy, (for all enterprises, not only commodities production). I am less clear that linking currencies (either strictly or flexibly) to precious metals or baskets of commodities alleviates that problem. Certainly to the extent that our monetary authorities choose to play it fast and loose as has happened in the United States, the imposed discipline at least keeps us from making our own bed. But, assuming a different alternative- a responsible monetary authority unconcerned with its public image (e.g. the Paul Volcker Fed)- that advantage dissipates and the vagaries of Peruvian politics, ARAMCO security measures and Russian obstructionism of Kazak oil infrastructure start looming larger as monetary landmines.
Btw, any chance you could point me to some instructions on how to format, (offset grayed out text, bold, italic, etc.)?
Terje: For instance if the price of oil falls US$0.50 tommorow, then does this mean that the world wants less oil or that it wants more dollars? The producers of oil (and the explorers and investors etc) are left to guess.
Now that’s an interesting hypothesis. In general, the price of oil is going to go up which will make it difficult to detect a decrease in the demand for dollars. Maybe this “confounding” is advantageous to Uncle Sam because this type of ambiguity decreases the risk of a run on the bank. When you’re running a huge pyramid scheme, an insurance policy against the whole thing collapsing is pretty valuable…
Are you saying that a fed led by Paul Volcker is an example of a fed unconcerned with its public image. Or the opposite?
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Formating tips:-
The trick is to use angle brackets where my following examples use curved brackets. Angle brackets are just the “greater than” and “less than characters”.
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Terje,
In answer to your question, I was saying the former but I should probably qualify that somewhat. Volcker had a conviction that he needed to be aggressive to stamp out the overwrought inflation expectations and commodity speculation and he did so in spite of his policy making causing the largest economic recession since the depression. That wasn’t too popular and took some intestinal fortitude (even though some of the current entrenched interests that made the most noise over such things as “irrational exuberance” did not exist then). Greenspan’s version of conviction is to issue dire warnings and then accommodate all manner of excess including the vaunted Greenspan Put.
So I guess my opinion of Volcker as a policy maker could be underinformed, even as I am pretty sure he’s an honorable man. Furthermore, I’m probably implying too much emphasis on the central bank’s role when the other regulatory authorities including the OCC and SEC carry a handsome portion of the blame for the fix we’re in (this is beginning to garner more attention from all comers as people come to grips with the massive and inconceivably ignored agency problems of our malevolent financial system).
Actually, the seignorage thing has two potentially great consequences, even though they are not currently material. It may be important for the USA to factor these in when making decisions on the matter. They are:-
– seignorage can be used to accumulate material assets over time even when it is at a low level (it looks like “investment” but it is really a wealth transfer, and “free” trade rules may force the door open for it); and,
– the level can be raised in emergencies and some of the inflation will then be exported, allowing the costs of this tactic to be spread from the US domestic economy.
That is, it is in US interests to keep this slippery slope available as an option.
So if I understand you are saying:-
1. A commodity price basket as a target of monetary value might be more disiplined that what we have today. I AGREE.
2. Paul Volcker when he ran the Federal Reserver created a better monetary result compared to today or to the days of commodity price standards (eg pre 1971). I DISAGREE.
3. A commodity price standard is subject to commodity supply shocks. I AGREE WITH QUALIFICATIONS.
Todays monetary regime has the benefit of being based on a price rule (like the gold standard was). The price it focuses on is that of the consumer price basket and the cost of credit (ie interest rates). As such it is far more stable than the previous regime. In the Volcker days the targets were Monetary quantities (a quantity rule as opposed to a price rule) which led as you observed to a recession.
A commodity price target is subject to supply shocks. However these have never been as severe as you might imagine. Certainly not as bad as the shocks that governments (central banks) in their indiciplined ways have produced at numereous times.
>20 countries have 95% of the worlds proven reserves and production capacity,
>i fail to see how its possible that most oil is consumed in the countries in which it is produced
Well those 20 countries also include several of the largest consumers – including the US, China, the UK and Canada.
Exporters from the 13 largest exporters totalled 38.3 million barrels per day in 2004 (http://www.eia.doe.gov/emeu/cabs/topworldtables1_2.html
).
World production during 2004 averaged 84.4 million bpd
(http://www.eia.doe.gov/emeu/ipsr/t21.xls)
Terje,
The problem with the basket of goods as a measure of price, and I have no doubt you are well aware of this isnce you’re far better read than I am, is that the contents of the basket are so pathetically open to manipulation. If a governemt, or reserve bank, wants to trumpet it’s inflation fighting prowess, out go the things that have ramped up (say, energy, or coffee beans). And then there’s the idiocy and circular arguments of hedonic accounting grossly exaggerating price decreases for some goods, so better put those goods in. At least back when inflation equaled rate of change of money supply, it was (mostly) objective. And of course, using that measure, inflation’s been running around 10% a year (give or take a bit) since Greenspan took the genie out of the bottle and created cheap money in the mid 90s. Bubbles never do good.
-peter
Terje,
First, I would say that the targeting of monetary aggregates by the Volcker Fed was not responsible for the 82 recession. This is to say, the recession wasn’t the result of policy implementation, but rather of policy, namely (extremely) restrictive policy. Now, I’m not qualified to make an esoteric argument about the merits of affecting price stability through the targeting of monetary aggregates or interbank lending rates, but I am qualified enough to know it’s esoteric (and that the side one comes down on is highly correlated with the fervor with which one believes in free markets, itself typically correlated with the extent of one’s obtuseness). Of course, there is a coincidental argument that supports the targeting of monetary aggregates over interbank lending rates, and that is it controls for “financial innovation” i.e. the changing institutional landscape that facilitates ever growing quantities of credit short rates be damned.
As for my option of the merits of the current Fed regime vs. Volcker’s, I couldn’t be more opinionated. As I see it, the current Greenspan/Bernanke Fed has presided over vast credit creation that has so far had the following consequences, 1) dramatic deindustrialization of the United States, 2) the creation of a community of special interests with immense political influence that profit from perpetuating destabilizing credit excess (namely GSE’s and the legion mortgage and home equity apparatus, hedge funds & broker dealers, i.e. the leveraged speculating community) 3) global overabundance of liquidity and attendant excess investment 4) eye watering trade and current account deficits 5) myriad asset bubbles.
Now, these things are related and there is feedback and causation galore, however, the central point is that this has all been facilitated by a central bank that is happy to support demand come hell or high water, no matter how much money it needs to print. It has been able to do this without price instability to date due to external conditions out of its control. That it should have allowed this simply because price stability is its “only mandate” is madness and an abdication of responsibility to a degree difficult to comprehend. This is especially true when you consider that the ultimate consequences of the gross imbalances that have resulted from its policies will ultimately drive systemic stress and, IMHO, systemic failure- something well within the Fed’s remit.
Volcker’s Fed, by comparison, was far less rigid in its ideology. It allowed for the fact that it wasn’t omniscient. It analyzed circumstances as they arose and was willing to accept a conclusion that it hadn’t foreseen; and it acted accordingly. In other words it was responsible and accountable- two words one can be fairly assured will never be associated with Greenspan’s legacy.
Peter,
I don’t see how targeting the money supply is more objective than any of the many other targets that central bankers currently or previously have chosen.
A. Targeting the money supply is:-
1. A quantity rule.
2. Objective.
3. Reasonably accountable. Although not easily so.
B. Targeting the price of gold is:-
1. A price rule.
2. Objective.
3. Very accountable.
C. Targeting the price of credit (ie interest rates) is:-
1. A price rule.
2. Objective.
3. Very accountable.
In for a monetary quantity rule you would need a large statistics department to gather the data and test whether the central bank was honestly sticking to its target.
In a gold standard you just ring up the bullion markets and get todays price and you can see how close the central bank is to target.
In the current regime you just ring up the short term money markets and get the current overnight interest rate and see how close the central bank is to target.
The latter two types of monetary policy (ie price rules) are much more transparent.
I also believe fundamentally that a price rule is both more natural and more useful than a quantity rule. Back when the only money was gold or silver coin we had a price rule. If the value (real price) of gold increased then more would be mined or imported. As such the quantity was never fixed but rather the dynamics of the market place worked to achieve the quantity that ensured a stable value (price) for gold/silver.
I concede that a basket can be manipulated. At the moment I think the basket we use (CPI) has too many consumer goods and not enough commodity goods. This makes for a target that is pretty forgiving of monetary errors. Nominal consumer goods are at the end of the supply chain and there are a lot of buffers in the system that will hide monetary errors. Commodity goods are global and fungible and as such they reveal (and if used would allow correction of) monetary errors more immediately.
As such I want a better basket even though baskets are flawed. I could argue for a system without a basket at all but for the moment I would settle for incremental improvements.
Regards,
Terje.
P.S. I don’t think inflation has ever been merely a measure of change in the money supply. Although I know that the Austrian economists like to characterise it that way. Even in the late 1970s and early 1980s when targeting the money supply was all the rage it was not a substitute measure for inflation.
Majorajam,
There has been no formal Greenspan system to speak of. He has been a complete pragmatist. As such we can’t really evaluate the system except by its results or by disecting his brain in ways that science has not yet devised. Personally I have an in principle problem with a monetary system being piloted by a guy that flys by the seat of his pants. However the media seems to love it because their is always a lot of guessing to report on. If we were to characterise it as a system we would say that it is like a price rule.
Volcker tried to follow a rule. We might say that there actually was a Volcker system, which related to the “scientific” growth of the money supply. It was a shocking system in terms of results, although it did have the merits of being a system.
Pre 1971 we had the gold standard. Or a version of gold standard. It was a system. I think it was superior than the other two.
Bernanke has argued for a system. He is in favour of formal inflation targeting. However he is a concensus man so he won’t be mandating the adoption of a system any time soon.
I am in favour of:-
1. A system.
2. A price rule system.
3. A non government managed price rule system.
However as I said to Peter I will take modest reforms if that is the best we can get and if they move us in the right direction.
Regards,
Terje.
Terje,
I think we are in complete agreement. I took your earlier reference to a price refernece to mean a basket of goods, not an objectively priced, non-fiat currency like gold. And I agree that such a price rule makes more sense than a quantity rule in the era of fiat currencies (I suppose in the era of gold backed currencies, rate of change of money supply is inflation since the backing for the money supply isn’t changing, or only changing very slowly.) Your explanation of a feedback mechanism that regulates the value of curreny against gold is probably only true in a punctuated equilibrium sense – brief periods of desperate government issuing of money to fund wars etc tended to cause sudden devaluatons in that currency, or the replacement all together of that currency, but not in the practical utilty value of the equivalent amount of gold. An acre of land still costs roughly the same in gold, regardless of the currency the gold is valued in (ie, exactly your argument about commodity prices). I’m sure you’ve heard all this blather 101.
I can’t see governments surrendering fiat currencies or basket-of-good manipulation. Any ideas?