Saturday, December 20, 2008

Why Is Everything So Hard to Understand?

The largest supplier of petroleum to the United States is not some axis-of-evil no-goodnik Arab country. It is the friendly dominion next door. When oil was horribly expensive a month or two ago, the Canadian dollar was around US $1.03, which historically is high. Today it has fallen to a more typical US $0.82.

So did the fall in the oil price cause the fall in the Canadian dollar? Or did the fall in the Canadian dollar cause the fall in the oil price? I think the answer is "Yes".

Oil imports have to be paid for in prices nominally in US dollars, but actually in the producer's currency, in this case Canadian dollars. An oil price decrease in Canadian dollars is amplified by the simultaneous decline in the price of Canadian dollars. So a small price decrease caused by a small decrease in demand becomes amplified by the simultaneous decrease in the value of the currency it must be paid in.

It is that amplification, together with the general inelasticity of both supply and demand for oil, that causes wild price swings. I think that is why the price of a gallon of gasoline fell from almost $4 to $1.70 in a few days.

The moral of which is that the volatility in the price of oil is lying in wait. It will come back.

We are being told that the decline in the price of oil is one element of a deflationary spiral. That is an over-simplification. Deflation is to be feared only if it leads to declining wages. If wages remain the same and prices decline that means everybody is getting richer in terms of the amount of goods and services they can buy with their incomes. Absent wage decreases imposed on oil company employees, the only cost of lower prices is dimished oil company profits. These have been obscenely high during the price run up and I doubt much is to be feared from their decline.

So deflation is a good thing UNLESS it leads to declining wages or layoffs. If it doesn't, it just means workers get more for their wages than they did before.

Historically overall deflation has generally led to economic contraction, widespread unemployment, and falling wages. It does not follow that declining prices in a single sector, like oil, is always a bad thing.

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