About This Blog

Ludwig von Mises (1881-1973) was the greatest economist of my time. His greatest works can be accessed here at no charge.

Mises believed that property, freedom and peace are and should be the hallmarks of a satisfying and prosperous society. I agree. Mises proved beyond a shadow of a doubt that the prospect for general and individual prosperity is maximized, indeed, is only possible, if the principle of private property reigns supreme. What's yours is yours. What's mine is mine. When the line between yours and mine is smudged, the door to conflict opens. Without freedom (individual liberty of action) the principle of private property is neutered and the free market, which is the child of property and freedom and the mother of prosperity and satisfaction, cannot exist. Peace is the goal of a prosperous and satisfying society of free individuals, not peace which is purchased by submission to the enemies of property and freedom, but peace which results from the unyielding defense of these principles against all who challenge them.

In this blog I measure American society against the metrics of property, freedom and peace.

Saturday, March 3, 2012

Are Gas Prices Soaring Because The Value Of The Dollar Is Falling?

In the last week or so there have been a number of articles posted on the internet which assign the cause of rising gas prices to the falling purchasing power of the US Dollar.

The first article I noticed on the subject was posted March 2 by Julie Borowski at Peace, liberty and sound money. Ms. Borowski's post is titled: "Gas Prices are Rising Because the Dollar is Falling." In the comments section of her post a reader pointed me to the following YouTube of a TV report which apparently aired Feb. 29. The reporter, Ben Swann, claims the price of oil is rising in terms of US Dollars because the US Dollar is being inflated and is, consequently, losing purchasing power. Hmmm.

Following the links in Ms. Borowski's post I found my way to an article posted on Feb. 29 by Nick Sorrentino at AgainstCronyCapitalism.org. Sorrentino references the source of his post as an article by Louis Woodhill posted Feb. 22 in Forbes Magazine.  Ms. Borowski also linked to an article by Eric Parnell which was posted on the website called "Seeking Alpha" on Feb. 22. Interesting...

Who started this train of reasoning is immaterial to me. The question in my mind is: Does the conclusion make any sense? Are gas prices really rising because the purchasing power of the US Dollar is falling? 

Let's delve into this question by considering the following graph which was included in Eric Parnell's post:

The graph shows an apparent correlation between rising gas prices and the Fed's recent bouts of "Quantitative Easing," i.e., injections of new quantities of money into the financial system by the Federal Reserve. Parnell explains the correlation as follows:
Gasoline prices have followed a predictable trend since the first days of Fed stimulus. During QE1, gasoline prices skyrocketed by +118%. Once QE1 ended in April 2010, gasoline prices immediately dropped by -27% in a matter of months, and this occurred during what is typically the strong summer driving season. Once QE2 was delivered to the market in August 2010, gasoline prices jumped another 92% by the end of this stimulus program in June 2011. Once again, the moment QE2 ended, gasoline prices retreated another -28% in a matter of months. Finally, since the latest Fed stimulus program along with the European Central Bank's own LTRO program, we've seen gasoline prices skyrocket another +30%. What is even more irksome is that much of this rise in gasoline prices has occurred during a time when gasoline consumption has been falling. Have the laws of supply and demand been repealed? No, they've just been severely distorted by policy action.
Clearly Parnell believes Quantitative Easing by the Fed has not only a direct effect on gas prices but an immediate effect. However, a statistical correlation is not the same as cause and effect. In order for Parnell's belief to be true, he must explain how an injection of money into the system by the Fed directly causes gas prices to rise, especially in view of the fact that, as he observes, "gasoline consumption has been falling" during much of the time gas prices have been rising. Moreover, he must explain how this direct cause is immediate.

Parnell knows that, when the quantity of money in the financial system increases, prices will necessarily and eventually increase. But why? There is no magic involved. The new money finds its way into the hands of consumers who bid up commodity prices. However, this process takes time. And the process works through supply of and demand for the specific commodity in the market place. If consumption of gasoline is down, higher demand for gas couldn't account for higher prices. And it defies credulity to believe that gas prices could begin to "skyrocket" in "the first days of the Fed stimulus."

It seems to me that Parnell and Borowski have it exactly backwards. It is not the falling purchasing power of the monetary unit that causes commodity prices to rise. On the contrary, it is the rising prices of commodities and services which result in a general, perceived fall in the purchasing power of the monetary unit. As new quantities of the monetary unit are injected into the system, the prices of commodities and services are bid up by those who are the recipients of the new money. In time, and by this process, the prices of all commodities and services are bid up resulting in a fall in the purchasing power of the monetary unit.

So why are gasoline prices rising precipitously if not because of a fall in purchasing power of the US Dollar? I'll offer an educated guess.

Gas prices may be rising because suppliers are witnessing a precipitous rise in crude oil prices and anticipating higher future production costs. 

Why are crude oil prices rising? Perhaps because it is not the US Dollar that determines the price of oil, but gold. As Louis Woodhill points out, the price of oil in terms of gold has remained fairly constant since 1971:
In terms of judging whether the price of WTI is high or low, here is the price that truly matters: 0.0602 ounces of gold per barrel (which can be written as Au0.0602/bbl). What this number means is that, right now, a barrel of WTI has the same market value as 0.0602 ounces of gold.

During the 493 months since January 1, 1971, the price of WTI has averaged Au0.0732/bbl. It has been higher than that during 225 of those months and lower than that during 268 of those months. Plotted as a graph, the line representing the price of a barrel of oil in terms of gold has crossed the horizontal line representing the long-term average price (Au0.0732/bbl) 29 times.
Although the US Dollar is the currency in which oil is usually traded, perhaps its role is only nominal. Oil suppliers are not stupid. They realize that gold is and has been the world's preferred store of value. Perhaps they have been pegging the price of a barrel of oil to an ounce of gold and, setting its price in US Dollars based on the value of the US Dollar in terms of gold.

This is pure speculation on my part. I'm not about to gather statistics and do the research. However, I know for certain that commodity prices do not rise magically and immediately due to an influx of a new quantity of money into the system. The laws of supply and demand are always responsible for changes in price. 

NOTE: I should make clear that by this post I am not saying that gas prices have not suffered from price inflation over the years. The prices of commodities and services rise and fall due either to goods induced changes or currency induced changes. I'm sure gas prices are going up and have gone up over the years do to both phenomena. My quarrel is that there is no direct and immediate correlation with monetary inflation.


John Galt said...

None of the talking heads have a clue of why the price of gas is rising. It is useless to listen to them and even more useless to try to refute them, since all their premises are false. That includes O'Reilly and Dobbs from Fox.

The most likely answer is supply and demand with seasonal factors. The price always starts rising in the spring in anticipation of accumulating stocks for the summer driving season. That is, the "upstream" increases but the "downstream" gets tight. No surprise there!

Geopolitical factors could be the monkey in the wheels of supply. It is based more in fear than in economic facts.

What I know is that neither Gold nor the dollar purchasing power or global value have anything to do with it. First, the dollar has actually been rising in value in the exchange rates for the last 3 months - against the Euro it has gone from 144-148/EU to 132/Eu now. As for gold, it has been steady with a slight tendency of descending for the same period. The gold index was at 185 in September. Since then it has hit a low of 148 by January 3. It stands now at 165. Scratch those two - the dollar and gold - out.

Sherman Broder said...

I like your comment. Supply and demand ALWAYS are responsible.

How much a factor do you think OPEC plays in price setting and supply control? It is, after all, a cartel.

John Galt said...

It is a weak cartel, as cartels go. We get 90-95% of our oil from domestic supply, plus Canada and Mexico, which are not members.

The strongest member of the cartel, Saudi Arabia, and even Kuwait, are friendly oil producers whose interest is to keep oil prices steady and don't rock the economic boat of Europe and America.

The aggressive ones are Iran and Venezuela, from whom we get practically zero (except through the third market).

Blaming OPEC for everything is a popular thing to do with the media, it makes good headlines to identify a "bad guy", but it is also because they are profoundly ignorant of the workings of the oil market (granted, it is not easy).

PD. Sherman, it would be good for your blog to change the clunky "Blogger" comments system for another one. Disqus and WordPress give you free systems that you can place in your blog. They give you instructions of how to put them in your "Blogger" blog.
You will get more comments.

Sherman Broder said...

Good suggestions. I'll look into it.

By the way, I struck out on my writing assignment, but you've probably gathered that.

John Galt said...
This comment has been removed by the author.
John Galt said...

Not to worry. It is my fault for giving you the impression that it was an 'assignment".

I didn't explain it properly. The piece was very lengthy, passing by far our space limits. So all I wanted was for you to edit it into a smaller 500-800 word piece. My suggestions of how to do it were out of place.

There'll be others!