China's Progression to Reserve Currency Status

When I first suggested in April 2009 that the RMB might develop into a reserve currency that displaced the $US, I recall that the comments ranged from surprise, through to 'don't be silly' (or words to that effect). Fast forwarding to the present, and the idea is now firmly in the mainstream, albeit without the part about displacing the $US. This is from Reuters:

China's yuan could become a reserve currency in future if the country undertakes further economic reform, International Monetary Fund managing director, Christine Lagarde, said in a speech on Sunday.

The IMF chief, speaking to a gathering of leading Chinese policymakers and global business leaders, added that China needed a roadmap for a stronger, more flexible exchange rate system.

China operates a closed capital account system and its yuan currency is tightly controlled, although Beijing has said it wants to increase the international use of the yuan to settle cross border trade and has undertaken a series of reforms in recent years to that end.

Following a pattern that China long ago established, this is another piece of news from Reuters:

Japan will buy 65 billion yuan ($10.3 billion) of Chinese government debt, the country's finance minister said on Tuesday, giving China a mark of approval in the credibility of the yuan as an international currency.

Other countries are investing in China through state agencies, but Japan's investment is by far the biggest in the yuan. As a currency with limited convertibility, such bets are symbolic of the shift in global power towards China as the world's fastest-growing major economy.

And later in the article:

Japanese purchases of Chinese bonds would also be a sign of credibility in Beijing's long-term efforts to elevate the yuan's status as an international currency. That effort so far has involved China's promotion of the yuan to settle trade.

Beijing has struck agreements with several nations from Malaysia to Belarus and Argentina on the use of the yuan in trade and other transactions. It has expanded a pilot programme started in 2009 into a nationwide one allowing firms to settle their trade in yuan.

In order to understand why the RMB is gaining ground, I would point to an article that I wrote for TFR magazine. The argument is simple:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.

We have all simply become so used to the $US as a reserve currency, that it is difficult to imagine the world any other way. This is why I used the idea of imagining a world in which the $US was not already the reserve currency. In a world where the $US was not a habit of mind, it looks like an absurd prospect. Nevertheless, the currency still retains a reserve status, and the diversification out of the dollar is a symptom of the shift in the habit of mind that is all that retains the dollar's status.

Another way to look at the rise of the RMB versus the $US is in terms of the utility of the currencies. At present, the dollar retains utility in trade, as the US still remains a very, very large economy. However, it must be remembered that the US runs an ongoing current account deficit, such that the utility also includes funding the US current account deficit.The US is a major exporter of goods and services, but still consumes more than it produces. And China is one of the countries that is responsible for the deficit in goods and services, and therefore an element of that utility is financing a current account deficit to fund the purchase of Chinese goods and services.

Although still a very important player in trade, the US gained reserve status for its currency due its former dominant position in world trade. As I hope the previous paragraph suggests, the dominance in trade is diminishing, albeit it is still important. Despite the reducing importance of the US in trade, large amounts of trade are settled in $US, and this is an economic structure that reflected the former position of the US in global trade. It is obvious that China has understood that the road to reserve status is rooted in the utility of a currency in settling trade, and they are using their growing trade strength in order to piecemeal displace the $US. The problem for the US is that it is apparent that, with regards to trade, the RMB has the potential to have greater utility in trade settlement.

The simple point is this. A currency only has underlying utility in its potential to buy goods and services. To use an economist's expression, all other things being equal, the country that produces the goods and services subject to the greatest overall demand should be the natural reserve currency.The currency's value is rooted in demand for its use to purchase goods and services. However, we do not live in the economist's world of all other things being equal; we live in a world in which the way that currencies are managed and the economic policy of the issuer impacts upon the underlying value of the currency. It is here that I return to the point made in the TFR article. Honestly, which currency would win in a world with no history of a reserve currency?

As I long ago argued, the key turning point for the RMB will be the use of the currency as the benchmark for trading in oil. This is what I wrote about the RMB in April 2009:

However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

In short, I argued that pricing and trading in oil in the RMB will be the signal that the RMB has really become a de facto reserve currency. This from Reuters:

HONG KONG, March 1 (Reuters) - After the impressive success of the offshore yuan trading in Hong Kong, China has now zeroed in on a new hub for its overseas renminbi trading - the Middle East.   

The three-year dream run of the offshore yuan trade settlement plan has given Beijing confidence to look beyond the region and boost the renminbi's muscle power in a big area: oil.

Industry sources told Reuters last Thursday that the Dubai International Financial Centre (DIFC), the United Arab Emirates' financial hub, may permit transactions in Chinese yuan from this year.  

"The internationalization strategy should move westward to find a supplementary region to the existing Asian region," said Cao Tong, senior vice president at CITIC Bank, adding that the oil-rich Middle East, Central Asia and Russia would be a good breakthrough.

The amount of trade settled in yuan jumped sharply to 2.08 trillion yuan ($330 billion), grabbing a 10 percent share of the total trade volume in the currency, compared with only 2 percent a year ago.

The same Reuters article later says:

What is more important is that if yuan is accepted and used by these oil producing countries, it will significantly enhance the currency's status in the global currency system.

In fact, the dollar's status as a global reserve currency is to some extent also because oil contracts are priced and settled in that currency.

China has already started accelerating its opening up of capital account by allowing yuan FDI and ODI recently, together with an ambitious outline of making Shanghai a global renminbi products innovation, trading and clearing center by 2015.

The timing could not have been better as the yuan is steadily appreciating which makes it more attractive, while the main currency-issuing countries are printing notes to solve their debt woes.

On this final quote I close my case on why the RMB will likely displace the $US, albeit nothing is certain or cannot be derailed (e.g. a major crisis in the Chinese economy). The surprising part is that it was so evident that this would be the path so long ago, but habit of mind prevented  so many from seeing what was right in front of them.

Inflation, Deflation or Hyper-Inflation

It now seems that both the UK and US have now used up most of their interest rate ammunition, in their hopeless attempt to reverse the slide into depression. The result is a further sinking of the £GB, and even the 'mighty' $US is finally wobbling.

One of the most interesting features of the latest moves to arrest the slide is the minutes of the Bank of England, which revealed their fears for a run on the £GB:

"The Committee discussed whether a larger cut was warranted," the minutes said. "Financial markets had priced in a cut of 100 basis points and there was a risk that going further could cause an excessive fall in the exchange rate. There was also a risk that an unexpectedly large cut could undermine confidence in the economy more widely."

The £GB's recent slide was, in part, prompted by ever more dire news about unemployment, which is now surging ever higher, ever faster, in a mirror image of the US problems. The simple truth is that, as I always predicted, none of the measures to 'fix' the economies of the UK and US are working. We have this from the Telegraph regarding the UK:

In comments which raise the ultimate prospect of wholesale nationalisation of the British banking system, Mervyn King said that "additional measures" are now needed to solve the crisis.

The £500bn rescue plan unveiled by the Prime Minister in October and since copied throughout the world is not encouraging banks to lend more to families and businesses, he said.

It is the most stark warning yet from the Governor that all his and Whitehall's efforts to bring the crisis to an end have not succeeded.

Banks now need extra support from the taxpayer if they are to return to normal lending, he indicated. Facing the worst financial crisis in living memory, UK banks have slashed the amount they lend out to homeowners, resulting in higher interest rates and tougher conditions for homeowners.

I predicted when the bailouts were first proposed that the bailouts would be ongoing, and this is proving to be the case. In the US they are already printing money, and the Bank of England is now openly discussing the option. As each day goes by, as each new ever more expensive, ever more desperate measure is implemented, the relentless bad news continues. Up to now, each measure saw a brief rally in stock markets, but this time, the fed's rate cut saw a fall in the Dow Jones Industrial Average. Even the herd instinct of the markets are no longer following the scripts of government.

Just to add to the pain, it now seems that OPEC are going to drastically cut oil production, which can only serve to add fuel to the fire of the crisis. Low oil prices were one of the few true stimulants to the moribund economy that would have had a positive impact. We can only hope that their agreement fails to have teeth in practice. I still remember people arguing with me (about six months ago), that my prediction of $US 60 per barrel was absurdly low. It seems it was absurd, but not because it was too low, but because it was way too high.

There is still talk of deflation, and this is one of the justifications for the printing of money. In some respects it is correct that there are deflationary pressures. In particular, the housing bubble means that homes are returning to a more normal measure. I always argued that house prices should be included in inflation, and would still argue that they should be now. However, I am not sure how the deflation of a bubble could ever be considered to be a bad thing. Painful, yes, but bad, no.

Unemployment will also create deflationary pressure on wages. I was once shown a chart by an economist that 'demonstrated' that wages do not fall during recessions. It was one of those classic models that economists love. However, at the time, I merely pointed out that the deflation in wages was just displaced into unemployment. A company has a choice; make workers redundant or give everyone a pay cut. In most cases they will not ask for the pay cut, as it is easier to externalise the discontent through redundancy rather than trying to manage to persuade all workers of a need for a pay cut. As such there is displacement. It is at times like now that the minimum wage will have a negative impact. It makes it even more necessary for some companies to opt for redundancy rather than across the board pay cuts.

On top of these factors is the fall in the prices of commodities, such as oil. However, the prices of these items is not straightforward as, for both the US and UK, the prices of many of the commodities is tied to the exchange rate (though many commodities are priced in $US - more of that later). For example, in the UK, the prices of fresh food are on the rise again, due to the weakening of the £GB.

Howard Archer, chief UK and European Economist at Global Insight, said: "Sterling is having an impact as most of our fruits are imported. This is not something that is going to disappear."

But he added: "There are several factors at play which will lower inflation and they will substantially outweigh the effects of the pound."

Perhaps I am being unfair to Mr. Archer here, as the article does not detail all that he said, but at what level does he think the £GB will fall to? This is the critical question that needs to considered in thinking about inflation. My own view is that the fall has a long way to go, and that will mean strong inflationary pressure. As commodity prices are falling, so is the £GB, and where the balance between the two might settle is still unknown. In the case of the US, the $US has only just started to wobble, so the effects of downward movement of commodities have been deflationary. However, the $US bubble will burst, and when it does, the deflationary effects will start to disappear.

Another element in the consideration of deflation is retailing and services. I need not detail or even reference the dismal state of these sectors, as their poor state is being widely discussed in both the US and UK. Some months ago, when discussing the prospects for inflation, in relation to my prediction of a sinking £GB, I saw the collapse in services as a counter to the inflationary effects of higher import prices. This appears to be the case, as much of the fat in the service sector created by the credit boom is being trimmed.

So how does this add up in aggregate - in the prediction of inflation or deflation? It is here that we come to the really tough part, because there is the role of governments in all of this already complicated scenario.

I have already mentioned that inflation or deflation is strongly tied to currency movements in relation to commodity prices. As the world economy contracts, the supply of commodities relative to shrinking demand is rising, meaning prices should continue to fall. For regular readers, you may remember my analogy of the world economy as being like a person running forward, who then hits a wall of maximum commodity supply, bounces back from the wall, then commences running forward again (what has recently happened to the world economy). As I described it, the wall was also moving forwards, but not as fast as the runner so that eventually he would run up against the wall again, only to bounce back. In the case of OPEC's production cut, the wall is moving backwards, not forwards.

However, my prediction for commodity prices starting to rise again was about four years forward. I have mentioned before that OPEC is problematic, but it seems they are throwing a major spanner in the works with their production cuts. This is a wild card, as the price of oil is an important element in inflation for the world economy as a whole (despite some economists insisting it was not as important as before).

Another wild card is state of the $US. I am certain that the $US is the greatest bubble in history, and one of very few predictions I have made that has been incorrect is that the $US should already have sunk. I never imagined that people would be quite so irrational as to put their faith in a currency sitting on top of a collapsing economy. My error was that I expected people to act with at least some rationality. However, homo economicus was always a myth, so I should have known better. Putting my previous error to one side, the underlying weakness of the $US must emerge at some stage, so the wild card in this case is not 'if' but 'when'.

My reasons for why both the $US and £GB are fundamentally weak currencies is quite straightforward. The strength of the currencies previously rested on two platforms. One of these was inward investment, which was due to the illusion that the economies were successful, due to their credit inflated GDP growth, and the other was that creditors to both the US and UK needed to buy the $US and £GB in order to lend into each of the economies. With collapsing economies, the inward investment will evaporate, and nobody but a madman (or government) would want to be a creditor to both of these countries at present. At the same time, both countries make less and less of anything that anyone wants to buy. This is best seen in the ongoing trade deficits which, according to the Economist (print edition, 6th-12 December, p106) were $bn 851 for the US, and $bn 185 for the UK for the last 12 months. Inevitably, as the currencies of both countries sink, these deficits will diminish but, as things stand, there is is a basic imbalance (and has been for a long time).

Add to these currency wild cards are the exchange rates set for the RMB, which is a total unknown, dependent upon the wisdom (or lack of it) of the CCP in Beijing, as well as whether China seeks to rescue its own economy by attempting to redeem the I.O.U.s from the US and UK.

As if we do not have enough wild cards in the pack, we can finally add in the possibility that, if the $US starts to fall dramatically, the oil states that peg their currency to the $US might abandon the peg once the $US commences to collapse, and will the $US remain the currency of commodity pricing in general?

So where does this leave the question of inflation versus deflation? As you will note from the brief summary above, there are many factors that are inter-related. My view, based upon a heuristic evaluation (a smart expression for a 'guesstimation') is that any deflationary pressures in the US and UK at present will be strongly offset by a future currency collapse. The printing of money, in conjunction with the horrific level of government borrowing, will take a necessary and painful adjustment in currencies, and turn the adjustment into a complete collapse of the $US and £GB. In the case of the UK, the inflationary pressures have already commenced with the ever weakening £GB, but for the US, it will take a much firmer shove. However, if the $US does collapse, as I believe it will, I believe that the pegs and $US pricing will be unsustainable, leading to a 'shock' hyper-inflation.

Note 1: I am sorry to be so relentlessly gloomy, but I just can not see a positive side in anything that is going on. Even the bright point of the collapse in oil prices is now looking less positive. I am not sure I have covered all of the points here as well as I should, but I hope that the argument stands up. For regular readers, I am sure that much of what I am saying will make sense, as the foundation of what I am saying is built in many previous posts. For new readers, I would recommend the links at the top left of the blog.

Note 2: I have had some interesting comments again. Jeremy expresses complete cynicism, suggesting that whichever flavour of the politician, it will make no difference, and Steve Tierney expresses his concern that the public are buying the idea that the economy can be 'fixed' with ever more government borrowing and money printing. Steve reverses his previous optimism about people in face of the rising support for Gordon Brown due to his 'handling' of the economy. Like you Steve, I am endlessly disappointed (an anonymous poster also makes a similar point after reading the Guardian 'Comment is Free' section. I can not but help myself in agreeing with these concerns, and writing this blog is my small contribution to trying to make people face reality....

Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball.....

Note 3: If you thought I am gloomy, you might want to visit here if you want to see real gloom. An anonymous commentator recommends this blog.

Note 4: I have had some comments on my post on taxation reform. Lemming asks what I think about monopolies in my proposal. I still need to post on regulation, but I do think that one of the key regulatory roles of governments is to ensure that there is fair competition in markets. I do not have the quote to hand, but Adam Smith made a very good point about how, as soon as any group of merchants sit together, they will seek to conspire against the public. At least, that is the basic idea he is discussing...Lemming also, asks in a second comment what I think about individuals growing rich, and sucking money from the bottom to the top. In particular, he asks whether this pulling of money from consumers eventually leads to depression. It is an interesting point but, if the rich individuals invest this money into productive assets, then everyone gains. If the money is lent into consumption, then it will eventually lead to the mess that we are in now. I hope that I have not done Lemming's point an injustice, so you should read the orignial comments.

Also on the subject of taxation, Ivan makes the following point:

One thing, you mentioned tax free allowances - they would add massive complication and cost to a flat tax. I would propose that negative taxation would cover any free allowances, make the system simple and possibly finish up adding to the amount of tax collected.

I am not sure that having a single fixed tax free allowance is complicated, or am I misunderstanding your point? Please feel free to clarify, and I will (time allowing) try to respond.

Note 5: I have still not started work on the reform of the banking system, so apologies for this. I hope to get started soon, but have several distractions pulling me away from the subject. I will do my best....

Peak Oil and the Credit Crunch? Any Relationship?

Note Added 30 July: I have been rather lazy in my use of the expression peak oil, as has been pointed out here.

Peak oil is defined as the point at which production is about to go into actual decline, which means that prices would actually rise. By contrast I have discussed peak oil as the point at which reserves are being exhausted faster than they can be replenished, or more efficiently extracted, which is not strictly correct, but which reflects the arguments of many peak oil proponents. In other words they claim that we have reached the peak for these reasons.
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I have had some comments/questions posted, so I thought I would answer these over my next couple of posts.

The first is a question in response to my post; 'The Economic Collapse is Starting'. The question is as follows:

'What connection do you see between the 'credit crunch' and high oil prices? While I can see that the housing bubble and our lack of wealth creation were ultimately unsustainable, are we also witnessing a genuine 'peak oil' effect?'

It is certainly an interesting question, and one I have not thought about directly before. As such I will give my best stab at an initial answer. Perhaps with further reflection I may have a more developed answer, but for the moment this is a first attempt.

I attended a talk on the subject of peak oil recently in which it was suggested that we had already reached the peak, and that it was all downhill from here. On the other hand I saw a video of a very interesting talk by Bjorn Lomberg in which he pointed out that we have had peak oil scares since the 1930s[i]. Whilst agreeing that, in principle, easily pumped out of the ground oil is finite, no one is really certain when it will reach a peak or run out. Furthermore, there are many sources of oil that may become more economic with improved technologies, and that oil is (primarily) just an energy source with a potential to be substituted by other energy sources (again, with the proviso that technological development can make such sources economic).

Let’s assume for the moment that the doomsters are right, and that we have reached peak oil. Would this explain the recent spike in oil prices?

The first point to make is that reaching peak oil is a long way away from running out of oil. Regardless of the peak there is still enough easily accessible oil to last the world for decades on current consumption levels. As such, why would reaching a peak cause a spike in prices now? Such a spike could only be the result of hoarding oil against the day when supplies run out. With decades of oil left to be pumped such speculation would, to say the least, be rather premature.

The second point is to ask the question of how expensive oil actually is. The Economist recently ran an article that pointed out that, whilst expensive, oil is not as expensive as we imagine - if inflation is taken into account[ii]. However, since that article, prices have continued to rise. There is no question that oil is now relatively expensive, though still not as relatively expensive as many think. A better way of looking at oil prices is to view the recent low prices as being one of the foundations of economic expansion over the last two decades as there was too much oil capacity compared with demand, and that oil prices are now adjusting to the expansion in the world economy.

As such, one reason for the relatively high price is quite straightforward. The overall output of oil has declined in the face of world economic expansion, though the decline has nothing to do with peak oil[iii]. In short, it is no different from the bottlenecks that have created high prices in many other commodities (an interesting example of such a bottleneck is the lack of capacity for tyres for the heavy earth movers used in mining). What we are now witnessing is that the world has reached capacity/bottlenecks in many commodities and, regardless of the so called ‘credit crunch’, growth was going to slow whilst capacity in commodity industries caught up with demand. Oversupply has turned into under-supply, leading to higher prices, and higher inflation as a result.

Another reason for the high oil price is the fall in value of the $US, as oil is priced in $US. It is here that the problem becomes more complex and I am not sure that I can do justice to this in a quick reply. The fall in the $US is the result of a rebalancing of the world economy. When a currency devalues, it actually makes a country economy poorer, as the cost of imported goods goes up, which is an indirect form of wealth reduction. The U.S. (and U.K.) is becoming poorer.

The relative increase in oil prices is just one facet of the reduction in wealth of the U.S. The U.S. has funded economic expansion (not growth) through borrowing, and the result is that whilst appearing to grow richer, the country has become poorer. The fall in the value of the dollar is recognition that the U.S. is no longer selling enough goods or services to support the value of the U.S. currency. Countries such as China already have a massive dollar surplus, but the U.S. is not producing enough goods or services for the dollars to have utility – there are not enough goods and services at competitive prices to buy. As such the value of dollars has fallen.

Only through relative impoverishment can the U.S. regain its competitive position in the world economy. Quite simply, the U.S. economy as a whole had ceased to be competitive in global markets. The only way out for the U.S. is to reduce its cost base, and that means reducing labour costs, and the costs of managing its infrastructure and government. Devaluation (making everyone in the U.S. poorer), is one process of making this adjustment. As such, high oil prices are partly the result of the devaluation of the U.S. currency, and that is the direct result of the lack of competitiveness of the U.S, economy.

Does this relatively high oil price have any relation to the so called ‘credit crunch’? I do not like the expression credit crunch, as it has taken on the status of being like a force in its own right – disconnected from the causation. The causation is that financial institutions plunged into ever more reckless forms of lending. The lending (inevitably) went wrong, leaving banks with battered balance sheets, and creating a loss of confidence in their ability to manage risk. Of particular note is the lending has been into consumer/mortgage debt, and this debt drove so called ‘economic growth’ (expansion) in many western economies. The credit crunch is therefore not the result of high oil prices, but the result of foolish lending.

The interesting feature of the foolish lending is that the banks chose to lend into the consumer market, rather than using the money to expand manufacturing and other productive business. This is a reflection of the fundamental lack of competitiveness in the U.S. (and U.K. economy). The fact that lending to high risk consumers (sub-prime) was judged a better investment than investment into business says much about the dire state of the competitive position of the U.S. economy.

The credit crunch and high oil prices are linked in a couple of other respects. The boom that has been supported by the debt money-go-round has expanded demand for goods and services, and this demand has been the source of strained capacity in commodities. Furthermore the boom in oil prices has seen the accumulation of vast reserves of capital in some of the big oil producers. This accumulation has seen sovereign wealth funds, for example, bailing out the banking system with injections of capital (e.g. Abu Dhabi's sovereign wealth fund invested $7.5bn in Citigroup). In this respect the high oil prices are supporting the banking system and ameliorating the effects of the credit crunch.

On the other hand, the inflation caused by high oil and other commodity prices is a further downward lever on consumer spending, thereby speeding the rebalancing of the Western economies towards relative impoverishment (note the use of the term relative). The situation, as it now stands, is that the world is entering into a period of (at least) a lull in growth, or possibly economic contraction. The cause for the contraction is a combination of capacity constraints, and the problems of the banking system, resultant from the bursting of the credit bubble. The two causes are separate but related (which sounds contradictory?) but are coming together at the same time, creating a double whammy. However, the problems with commodity prices are going to be temporary. The fall back in world economic growth that is taking place is going to reduce demand for commodities, just as more capacity for many commodities is coming on stream (though the mining companies and oil producers have been more cautious in their expansion than in past booms). For example Saudi Arabia has agreed to increase production, though not by a very large amount. Also, high oil prices are already spurring action to reduce demand, for example leading governments to reduce fuel subsidies and car manufacturers to switch away from manufacturing ‘gas guzzlers’.

Having said that demand for commodities will fall, as the world economy slows, a counter-effect will be the ongoing readjustment of the U.S, economy, with continued pressure on the dollar for some time. Whether the increase in supply will outstrip any further weakening of the dollar becomes the question. My own view is that the increase in supply will see oil falling back in price in about six month’s time. My best guess, and it is no more than that, is that in two year’s time, oil will be back to about $US60-70 a barrel. This is based upon the provision of a small increase in capacity, a drop in demand, set against a further weakening of the dollar. Lots of ‘ifs’ - which is why it is a best guess.

What I am saying is that there is a relationship between oil prices and the ‘credit crunch’, but not in the respect that high oil prices have caused it. The idea that ‘peak oil’ is reflected in the price is unlikely in the extreme. The high oil prices stem from the underlying weakness in the U.S. economy and (temporary) problems of capacity. The credit boom may have fuelled the world economy and high oil prices, but the credit crunch will see oil prices fall back. What we are actually seeing is one of the mechanisms of economic rebalancing in action.

I have perhaps answered the question in a very indirect way. I hope that the answer makes sense. As I said, it is an interesting question. It raises some interesting points. For example, the way in which the world economy has come to a period in which bottlenecks have started to constrain growth and also, more interestingly, the rebalancing of economic power from West to East. The rise of the importance of sovereign wealth funds (including the Asian ones) is just one example of the rebalancing, the fall in the value of the dollar another. I have not mentioned the rise of the Euro, the status of the RMB, or the Gulf States’ currency pegs, and many other factors in this picture. The problem here is that any question starts to open up many more questions, and it is impossible to cover them all in short answer. As such, for what it is worth, I will leave the question there. Perhaps with greater reflection I will be able to offer a better answer, but hope that this suffices for the moment.



[i] Sorry, I have hunted for a link but can not find one. In place of this, I have quoted a paper abstract below, though this lacks the punch of Lomberg's discussion:

'Predictions of imminent oil shortages have been made throughout the 20th century. Although all previous predictions have been false, in recent years a new generation of predictions based on the Hubbert model have become ascendant and attracted media attention. The Hubbert model assumes that a resource is limited and finite. Although conventional oil supplies are finite, it has proven difficult to estimate the size of the ultimate resource. Over the last 50 years estimates of the size of the world’s conventional crude oil resources have increased faster than cumulative production. The estimated size of the ultimate resource base will continue to increase in the future as unconventional fossil fuels come on line. Oil production from Canadian tar sands has already begun.'

Oil: Are We Running Out? by David Deming
http://www.energycrisis.com/deming/aapg_oil.pdf The important points are that peak oil has been predicted for many years. Oil is a finite resource, but the peak....every time it happens, it doesn't. This is not to say that we have not reached the peak of relatively easily extracted oil. In the simplest terms the boy has cried wolf many times. Is it real this time? No one can be certain.
[ii] http://www.economist.com/finance/displaystory.cfm?story_id=11066673

[iii] http://www.economist.com/finance/displaystory.cfm?story_id=11528901