Sat, 15 May 2004

OPEC not to blame for rising consumer prices

Christopher Lingle Bangkok

A recent announcement by OPEC that its members will cut supplies caused oil prices to spike and move towards an historical peak of over US$40 a barrel. Countries that are net oil importers fear that this action will spark a wave of rising consumer prices, exerting upward pressures on interest rates and a slowdown in economic growth.

Although the notion that consumer-price inflation is a cost- push phenomenon has been widely debunked, media commentators and some economists cling to this misguided notion. Rising consumer prices cannot be blamed on increases in wages or rising commodity prices for all these are a result of inflation of the money supply.

Such apocalyptic fears are grounded in part by the coincidental effects of oil price hikes engineered by OPEC in 1973 and 1974. At that time, the cost of a barrel rose from $2.60 to $11.50. Then a second round in 1978 pushed prices from about $14 a barrel to nearly $35. However, it is important to note that rising oil prices occurred during a time when there was a high and rising rate of increases in consumer prices.

As important as they might be, rising oil or other energy prices cannot be the primary cause of higher consumer prices. For this to be true, the quantity of money would have to be passive and adjust itself to accommodate input cost increases.

However, the reverse is true in that overall costs can only rise when there is an excessive expansion in credit or the money supply. In fact, attempts by OPEC to stifle production to support price increases would have a deflationary impact. Unless there are offsetting increases in money supply or credit, many other prices would be forced down.

This is because if the stock of money in an economy rises at a fixed rate, rising input costs in one sector will cause input costs in other sectors to fall. Otherwise capacity would have to be shifted elsewhere and would lead to a rise in unemployment. Costs and prices can only rise in all or most sectors if the central bank engages in monetary pumping by loosening of credit policies through lower benchmark interest rates.

And so it is that rising energy costs cannot push up most consumer prices in a sustained manner. But they could lower productivity increases that would inhibit capital investment and push up unemployment.

Conventional wisdom has it that previous oil price hikes by OPEC brought about cost-based pressures that pushed up consumer prices. Were this to have been true, then countries that were the largest importers of oil would have recorded the highest rates of consumer price increases.

Both Germany and Japan are and were highly dependent on imported oil. But during the 1970s Germany had an average consumer-price inflation rate of 7 percent while the rate in Japan was about 25 percent over the same period.

Australia had an inflation rate of 17 percent with a very high dependency on foreign oil, and the U.S. was then importing about one-half of its oil and had an inflation rate of about 12 percent.

Meanwhile, oil exporters Great Britain and Saudi Arabia had inflation rates of 25 percent and 35 percent, respectively.

These differentials in inflation rates relates to the rates of monetary expansion. The simple truth is that countries with the most irresponsible monetary policies had the highest inflation rates.

There is no doubt that international cartels can have a destructive effect on modern economies. But higher oil prices will not necessarily cause a slowdown in GDP growth.

Higher energy prices need not cause a slowdown in economic growth. As it is, such outcomes are more likely if governments try to delay the inevitable adjustments. For example, paying subsidies to farmers to offset rising oil prices will only hide the immediate costs while shifting them to the long-term.

And so rising input costs and higher consumer prices should be understood to be the result of interest rates being pushed to record lows and economies being flooded with new money and credit. In the end, not even OPEC has wrought as much damage as have irresponsible central bankers.

The effect of pumping money into an economy does not have a neutral effect since monetary expansion, whether new notes or expanding credit, will not be confined to the overall price level. Expansions of credit or higher money supply growth can spark a temporary economic boom.

Expansionary monetary policies introduce distortions into investment decisions that lead to rising asset prices, an expansion of production and increased demand for labor. Meanwhile, rising demand for imports contributes to the current account going into deficit and tends to lead to currency depreciations.

Of course there is considerable bad news here. Never mind rising energy prices since they are merely a sideshow. What is most disturbing is that the economic optimism cited in so many countries is based upon a wobbly platform of rising government debt and cheap credit.

The writer is Professor of Economics at Universidad Francisco Marroqumn in Guatemala.