A few days ago I continued my regular pooh-poohing of the perils of deflation, which is coming up again because of the fall in the price of oil.  As I said in that post, deflation that is associated with productivity is generally a good thing, but if its a result of a collapse in the money supply, well, that is a disaster.   And while the price of any single commodity falling can never be deflationary–since deflation is a monetary phenomenon–it doesn’t mean that we shouldn’t be concerned about the fall in the price of oil.

There are a whole host of reasons to be excited about falling oil prices:  energy is a significant expense to both consumers and producers; cheaper energy prices allows more production and higher levels of consumption.   As many commentators suggest, this is like a tax cut; and its a progressive tax cut in that the poor pay a disproportionate share of their income on energy.  Keynesian economists should stand up and cheer!  However, if you are in favor of higher fossil fuel prices, so that your preferred alternative energy source would ascend into dominance (such as President Obama’s former energy secretary), this is going to be an increasingly uphill battle.   So there are winners and there are losers with lower oil prices.

The real issue that has everybody excited is not that the price of oil has come down, but that it has been cut in half in six months:

You don’t have to be an economist to understand that this is not the way markets work.  You don’t see this kind of volatility in a vacuum.  So while there are quite a few questions about the dangers of low oil prices (e.g., harm to U.S. fracking industry)  the real question is what is behind the drop in oil prices?  And does that mean anything more broadly about the state of the world’s economy?

Let’s review at least a few of the possible contributors to the sharp drop in prices:

1.  Reduction in global oil demand due to emerging market slowdown.   China is slowing, and they are the largest marginal demander.  So why is China slowing?
2. Speculation may be unwinding in oil that was based on the middle east becoming a tinderbox.  With even ISIS selling oil, it doesn’t seem to matter who’s in charge of a particular sandbox, they want petrodollars.  The fear premium in oil may be unwinding; and when speculation is revealed as wrong, it never goes to a true equilibrium but rather undershoots.  So what enabled high speculation in oil?
3. The dollar has strengthened dramatically against most other currencies; oil is priced in dollars and therefore the price declines as the dollar strengthens.  So why is the dollar strengthening?
4.  Supply of oil continues to surprise to the upside.  I’ve read somewhere–can’t find it now–that every official estimate of U.S. shale production since 2007 has missed to the downside–we continue to produce more than anyone expects.
5. High energy costs are leading to significant increases in efficiency, especially when coupled with government subsidies for energy alternatives.

So what to make of this?  Economist Russ Roberts talks about economists often essentially telling “stories” with the facts that we have.  Especially when we are thinking about macroeconomic effects, often we have competing “stories” that we offer up to explain the world around us.  For many reasons, this may be the best we can do.  In any case, my story for a large part of this is my favorite bad guy–the Federal Reserve.  The Fed’s initiation of global liquidity, orchestrated with the Bank of Japan (BOJ) and the European Central Bank (ECB), led to an emerging markets boom after the financial crisis.  Essentially we exported our inflation to emerging markets.  Commodity prices rose dramatically after, but eventually the monetary stimulus winds down.  We seem to be reaching that point.  With low returns available due to ongoing central bank financial repression, that increases the motivation for leveraged speculators to try and multiply their small gains.  But with the end of the Fed’s QE, and with the BOJ & ECB renewed liquidity push, the dollar is strengthening dramatically.  The combination of all these events leads to large swings in prices–volatility increases with leverage, and in a world of small profits, leverage is the name of the game.

So what are the implications?  Well, first of all, Russia is getting crushed.  The Ruble has fallen off a cliff; cut in half this year.  Russia is dependent on energy exports for hard currency, so Mr. Putin’s dreams of empire may not be in his budget.  If he takes Ukraine from here, its not like he gets a financial winner.  Ukraine is broke, and Mr. Putin would have to put some money into his new satellite.    Likewise the socialist government of Venezuela is in desperate straits–I certainly expect default in the future.  There are often unforeseen consequences when large prices swings occur; it was the collapse of the Russian bond market in 1998 that almost led to a market meltdown.  How much leverage is out there that will have to be unwound?  Not just in oil, but in Russian and other oil producing nation’s debt?  If those on the wrong side of these trades have to liquidate other assets, what will happen to those markets?  For example, gold was under pressure for the last two days; some speculate that Russia is having to sell gold to provide the reserves necessary to protect the Ruble.

I continue to believe that low oil price per se is not a particular problem.  But it may be the canary in a coal mine that global finance is facing increasing volatility due to monetary induced capital distortions–we’ve made a lot of investments over the last few years based on the Fed’s low interest rate policies.  Many economists always wondered how the Fed was going to unwind its balance sheet.  Maybe we’re seeing some of early unintended consequences of its zero interest rate policy.