Bretton Woods, Nixon Shock, OPEC, Yom Kippur War, Oil Embargo, Stagflation, Paul Volcker, Ronald Reagan and Morning in America

Posted by PITHOCRATES - October 1st, 2013

History 101

(Originally published September 18th, 2012)

Under the Bretton Woods System the Americans promised to Exchange their Gold for Dollars at $35 per Ounce

Wars are expensive.  All kinds.  The military kind.  As well as the social kind.  And the Sixties gave us a couple of doozies.  The Vietnam War.  And the War on Poverty.  Spending in Vietnam started in the Fifties.  But spending, as well as troop deployment, surged in the Sixties.  First under JFK.  Then under LBJ.  They added this military spending onto the Cold War spending.  Then LBJ declared a war on poverty.  And all of this spending was on top of NASA trying to put a man on the moon.  Which was yet another part of the Cold War.  To beat the Soviets to the moon after they beat us in orbit.

This was a lot of spending.  And it carried over into the Seventies.  Giving President Nixon a big problem.  As he also had a balance of payments deficit.  And a trade deficit.  Long story short Nixon was running out of money.  So they started printing it.  Which caused another problem as the US was still part of the Bretton Woods system.  A quasi gold standard.  Where the US pegged the dollar to gold at $35 per ounce.  Which meant when they started printing dollars the money supply grew greater than their gold supply.  And depreciated the dollar.  Which was a problem because under Bretton Woods the Americans promised to exchange their gold for dollars at $35 per ounce.

When other nations saw the dollar depreciate so that it would take more and more of them to buy an ounce of gold they simply preferred having the gold instead.  Something the Americans couldn’t depreciate.  Nations exchanged their dollars for gold.  And began to leave the Bretton Woods system.    Nixon had a choice to stop this gold outflow.  He could strengthen the dollar by reducing the money supply (i.e., stop printing dollars) and cut spending.  Or he could ‘close the gold window’ and decouple the dollar from gold.  Which is what he did on August 15, 1971.  And shocked the international financial markets.  Hence the name the Nixon Shock.

When the US supported Israel in the Yom Kippur War the Arab Oil Producers responded with an Oil Embargo

Without the restraint of gold preventing the printing of money the Keynesians were in hog heaven.  As they hated the gold standard.  The suspension of the convertibility of gold ushered in the heyday of Keynesian economics.  Even Nixon said, “I am now a Keynesian in economics.”  The US had crossed the Rubicon.  Inflationary Keynesian policies were now in charge of the economy.  And they expanded the money supply.  Without restraint.  For there was nothing to fear.  No consequences.  Just robust economic activity.  Of course OPEC didn’t see it that way.

Part of the Bretton Woods system was that other nations used the dollar as a reserve currency.  Because it was as good as gold.  As our trading partners could exchange $35 for an ounce of gold.  Which is why we priced international assets in dollars.  Like oil.  Which is why OPEC had a problem with the Nixon Shock.  The dollars they got for their oil were rapidly becoming worth less than they once were.  Which greatly reduced what they could buy with those dollars.  The oil exporters were losing money with the American devaluation of the dollar.  So they raised the price of oil.  A lot.  Basically pricing it at the current value of gold in US dollars.  Meaning the more they depreciated the dollar the higher the price of oil went.  As well as gas prices.

With the initial expansion of the money supply there was short-term economic gain.  The boom.  But shortly behind this inflationary gain came higher prices.  And a collapse in economic activity.  The bust.  This was the dark side of Keynesian economics.  Higher prices that pushed economies into recessions.  And to make matters worse Americans were putting more of their depreciated dollars into the gas tank.  And the Keynesians said, “No problem.  We can fix this with some inflation.”  Which they tried to by expanding the money supply further.  Meanwhile, Egypt and Syria attacked Israel on October 6, 1973, kicking off the Yom Kippur War.  And when the US supported their ally Israel the Arab oil producers responded with an oil embargo.  Reducing the amount of oil entering America, further raising prices.  And causing gas lines as gas stations ran out of gas.  (In part due to Nixon’s price controls that did not reset demand via higher prices to the reduced supply.  And a ceiling on domestic oil prices discouraged any domestic production.)  The Yom Kippur War ended about 20 days later.  Without a major change in borders.  With an Israeli agreement to pull their forces back to the east side of the Suez Canal the Arab oil producers (all but Libya) ended their oil embargo in March of 1974.

It was Morning in America thanks to the Abandonment of Keynesian Inflationary Policies

So oil flowed into the US again.  But the economy was still suffering from high unemployment.  Which the Keynesians fixed with some more inflation.  With another burst of monetary expansion starting around 1975.  To their surprise, though, unemployment did not fall.  It just raised prices.  Including oil prices.  Which increased gas prices.  The US was suffering from high unemployment and high inflation.  Which wasn’t supposed to happen in Keynesian economics.  Even their Phillips Curve had no place on its graph for this phenomenon.  The Keynesians were dumfounded.  And the American people suffered through the malaise of stagflation.  And if things weren’t bad enough the Iranians revolted and the Shah of Iran (and US ally) stepped down and left the country.  Disrupting their oil industry.  And then President Carter put a halt to Iranian oil imports.  Bringing on the 1979 oil crisis.

This crisis was similar to the previous one.  But not quite as bad.  As it was only Iranian oil being boycotted.  But there was some panic buying.  And some gas lines again.  But Carter did something else.  He began to deregulate oil prices over a period of time.  It wouldn’t help matters in 1979 but it did allow the price of crude oil to rise in the US.  Drawing the oil rigs back to the US.  Especially in Alaska.  Also, the Big Three began to make smaller, more fuel efficient cars.  These two events would combine with another event to bring down the price of oil.  And the gasoline we made from that oil.

Actually, there was something else President Carter did that would also affect the price of oil.  He appointed Paul Volcker Chairman of the Federal Reserve in August of 1979.  He was the anti-Keynesian.  He raised interest rates to contract the money supply and threw the country into a steep recession.  Which brought prices down.  Wringing out the damage of a decade’s worth of inflation.  When Ronald Reagan won the 1980 presidency he kept Volcker as Chairman.  And suffered through a horrible 2-year recession.  But when they emerged it was Morning in America.  They had brought inflation under control.  Unemployment fell.  The economy rebounded thanks to Reagan’s tax cuts.  And the price of oil plummeted.  Thanks to the abandonment of Keynesian inflationary policies.  And the abandonment of oil regulation.  As well as the reduction in demand (due to those smaller and more fuel efficient cars).  Which created a surge in oil exploration and production that resulted in an oil glut in the Eighties.  Bringing the price oil down to almost what it was before the two oil shocks.

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Bretton Woods, Nixon Shock, OPEC, Yom Kippur War, Oil Embargo, Stagflation, Paul Volcker, Ronald Reagan and Morning in America

Posted by PITHOCRATES - September 18th, 2012

History 101

Under the Bretton Woods System the Americans promised to Exchange their Gold for Dollars at $35 per Ounce

Wars are expensive.  All kinds.  The military kind.  As well as the social kind.  And the Sixties gave us a couple of doozies.  The Vietnam War.  And the War on Poverty.  Spending in Vietnam started in the Fifties.  But spending, as well as troop deployment, surged in the Sixties.  First under JFK.  Then under LBJ.  They added this military spending onto the Cold War spending.  Then LBJ declared a war on poverty.  And all of this spending was on top of NASA trying to put a man on the moon.  Which was yet another part of the Cold War.  To beat the Soviets to the moon after they beat us in orbit.

This was a lot of spending.  And it carried over into the Seventies.  Giving President Nixon a big problem.  As he also had a balance of payments deficit.  And a trade deficit.  Long story short Nixon was running out of money.  So they started printing it.  Which caused another problem as the US was still part of the Bretton Woods system.  A quasi gold standard.  Where the US pegged the dollar to gold at $35 per ounce.  Which meant when they started printing dollars the money supply grew greater than their gold supply.  And depreciated the dollar.  Which was a problem because under Bretton Woods the Americans promised to exchange their gold for dollars at $35 per ounce.

When other nations saw the dollar depreciate so that it would take more and more of them to buy an ounce of gold they simply preferred having the gold instead.  Something the Americans couldn’t depreciate.  Nations exchanged their dollars for gold.  And began to leave the Bretton Woods system.    Nixon had a choice to stop this gold outflow.  He could strengthen the dollar by reducing the money supply (i.e., stop printing dollars) and cut spending.  Or he could ‘close the gold window’ and decouple the dollar from gold.  Which is what he did on August 15, 1971.  And shocked the international financial markets.  Hence the name the Nixon Shock.

When the US supported Israel in the Yom Kippur War the Arab Oil Producers responded with an Oil Embargo

Without the restraint of gold preventing the printing of money the Keynesians were in hog heaven.  As they hated the gold standard.  The suspension of the convertibility of gold ushered in the heyday of Keynesian economics.  Even Nixon said, “I am now a Keynesian in economics.”  The US had crossed the Rubicon.  Inflationary Keynesian policies were now in charge of the economy.  And they expanded the money supply.  Without restraint.  For there was nothing to fear.  No consequences.  Just robust economic activity.  Of course OPEC didn’t see it that way.

Part of the Bretton Woods system was that other nations used the dollar as a reserve currency.  Because it was as good as gold.  As our trading partners could exchange $35 for an ounce of gold.  Which is why we priced international assets in dollars.  Like oil.  Which is why OPEC had a problem with the Nixon Shock.  The dollars they got for their oil were rapidly becoming worth less than they once were.  Which greatly reduced what they could buy with those dollars.  The oil exporters were losing money with the American devaluation of the dollar.  So they raised the price of oil.  A lot.  Basically pricing it at the current value of gold in US dollars.  Meaning the more they depreciated the dollar the higher the price of oil went.  As well as gas prices.

With the initial expansion of the money supply there was short-term economic gain.  The boom.  But shortly behind this inflationary gain came higher prices.  And a collapse in economic activity.  The bust.  This was the dark side of Keynesian economics.  Higher prices that pushed economies into recessions.  And to make matters worse Americans were putting more of their depreciated dollars into the gas tank.  And the Keynesians said, “No problem.  We can fix this with some inflation.”  Which they tried to by expanding the money supply further.  Meanwhile, Egypt and Syria attacked Israel on October 6, 1973, kicking off the Yom Kippur War.  And when the US supported their ally Israel the Arab oil producers responded with an oil embargo.  Reducing the amount of oil entering America, further raising prices.  And causing gas lines as gas stations ran out of gas.  (In part due to Nixon’s price controls that did not reset demand via higher prices to the reduced supply.  And a ceiling on domestic oil prices discouraged any domestic production.)  The Yom Kippur War ended about 20 days later.  Without a major change in borders.  With an Israeli agreement to pull their forces back to the east side of the Suez Canal the Arab oil producers (all but Libya) ended their oil embargo in March of 1974.

It was Morning in America thanks to the Abandonment of Keynesian Inflationary Policies

So oil flowed into the US again.  But the economy was still suffering from high unemployment.  Which the Keynesians fixed with some more inflation.  With another burst of monetary expansion starting around 1975.  To their surprise, though, unemployment did not fall.  It just raised prices.  Including oil prices.  Which increased gas prices.  The US was suffering from high unemployment and high inflation.  Which wasn’t supposed to happen in Keynesian economics.  Even their Phillips Curve had no place on its graph for this phenomenon.  The Keynesians were dumfounded.  And the American people suffered through the malaise of stagflation.  And if things weren’t bad enough the Iranians revolted and the Shah of Iran (and US ally) stepped down and left the country.  Disrupting their oil industry.  And then President Carter put a halt to Iranian oil imports.  Bringing on the 1979 oil crisis.

This crisis was similar to the previous one.  But not quite as bad.  As it was only Iranian oil being boycotted.  But there was some panic buying.  And some gas lines again.  But Carter did something else.  He began to deregulate oil prices over a period of time.  It wouldn’t help matters in 1979 but it did allow the price of crude oil to rise in the US.  Drawing the oil rigs back to the US.  Especially in Alaska.  Also, the Big Three began to make smaller, more fuel efficient cars.  These two events would combine with another event to bring down the price of oil.  And the gasoline we made from that oil.

Actually, there was something else President Carter did that would also affect the price of oil.  He appointed Paul Volcker Chairman of the Federal Reserve in August of 1979.  He was the anti-Keynesian.  He raised interest rates to contract the money supply and threw the country into a steep recession.  Which brought prices down.  Wringing out the damage of a decade’s worth of inflation.  When Ronald Reagan won the 1980 presidency he kept Volcker as Chairman.  And suffered through a horrible 2-year recession.  But when they emerged it was Morning in America.  They had brought inflation under control.  Unemployment fell.  The economy rebounded thanks to Reagan’s tax cuts.  And the price of oil plummeted.  Thanks to the abandonment of Keynesian inflationary policies.  And the abandonment of oil regulation.  As well as the reduction in demand (due to those smaller and more fuel efficient cars).  Which created a surge in oil exploration and production that resulted in an oil glut in the Eighties.  Bringing the price oil down to almost what it was before the two oil shocks.

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FUNDAMENTAL TRUTH #63: “There is no such thing as a monopoly in free market capitalism.” -Old Pithy

Posted by PITHOCRATES - April 26th, 2011

There is always Competition

Once upon a time, back in my youth, I sat in a seminar on venture capital.  I learned that venture capitalists are very wise.  And very careful about where they invest their money.  For them it’s not so much as making a return on an investment.  They could do that easier by just buying stocks and bonds.  No, the venture capitalist wants more.  They’re often people who went from rags to riches on a great idea.  And they want to recapture that feeling.  By taking big risks with their money.  On something that could be the next big thing.  And if you got the next big thing, they have that important seed capital you need.  But you have to sell them first.  Really sell them.

All these years later, I still remember this one example about a small startup company that had the next big thing in security systems.  Or so they thought.  Theirs took advantage of the latest in technology.  Motion sensors.  Glass-break sensors.  Sound sensors.  You name it.  If anything happened that shouldn’t be happening, the system would detect it.  But it did more.  It made noises. Flashed lights.  To scare off would be thieves.  Because thieves like to break into quiet, empty places.  Not places where lights went on and off.  And sounds moved around.  It was a pretty impressive system.  And costly.  It would set a business owner back quite a bit to install such a system.  But it would be worth it.  They knew they could sell it.  And, best of all, they would have a monopoly.  For no one else had anything close to what their system could do.  This was brand new.  And there was no competition.

 The venture capitalist smiled and thanked them for their presentation.  But he would not invest.  For they did have competition.  He said there is always competition.  They just failed to identify it.  They were sure there wasn’t.  They did their homework.  No security company out there had a system remotely close to theirs.  Then the venture capitalist smiled and said politely, “Perhaps not.  But I could buy a dog to do the same for less.”

High Gas Prices keep Gas Available

There is always competition in a free market.  If there is a market sector that is making high profits, other businesses will try to enter that sector.  To get a share of those high profits.  And when they do, there’s competition.  And prices come down.  That’s why gasoline prices are so close to each other at gas stations in the same geographical location.  One could raise their selling price by a dollar.  But if they did, their customers would just go to their competitors.  That’s what competition does.  Keeps prices down.  And makes people figure out how to sell the same thing for less.  Because if they can, they gain customers.  While their competitors lose customers.

Even oil companies feel the heat of competition.  High gas prices may hurt the wallet at the gas pump, but they are an incentive to them.  When the demand of oil grows greater than its supply, prices soar.  Why?  Because oil is becoming a more scarce commodity.  And the scarcer a commodity is the higher its price.  Simple supply and demand of economics.  These higher oil prices allow the oil companies to go after oil in the ground that was before too costly to bring to market.  Deep water drilling is more expensive than conventional drilling.  It simply wasn’t cost feasible before.  As was extracting oil from oil sands.  But high oil prices allow this extraction.  Bringing more oil to market.  Which ultimately will reduce the price of gasoline.  Or at least reducing the increase in the price of gas.  Simply by increasing the supply of oil to more closely meet the demand.  More importantly, even though prices may go up, gasoline will be available.  Unlike it was during the 1973 Oil Crisis.  Where OPEC cut oil deliveries to the U.S.  Instead of letting market prices rise to match the supply to the demand, the Nixon administration implemented price controls and rationing.  It seemed the kind thing to do for the consumer.  But by selling below the market price a lot of gas stations simply ran out of gasoline.  Resulting in further rationing.  Long lines at gas stations.  And scenes of people pushing their out-of-gas cars to the gas pump.

So, yes, even high gas prices can be a good thing.  It’s simply the market setting the price to make sure gas is available to buy.  We may not like the price.  And think the oil companies are gouging us at the pump.  But they’re not.  Even when they have record profits.  Though it is tempting to hate them after they post some of those record profits.  They sound huge.  And unfair.  But are they any bigger than other corporate profits?  Not really.  Oil companies have huge revenues.  So their profits are huge.  But as a percentage of sales revenue, they’re actually not that huge.  Here are some examples of net profit averaged over five years.  Chevron (8.22%).  BP (4.94%).  ExxonMobil (8.79%).  And how does that compare to other corporations?  Here are some from various sectors.  Home Depot (4.86%).  Sony (0.82%).  General Electric (9.93%).  Apple (17.60%).  Microsoft (28.20%).  If you look at net profit, the oil companies aren’t really making more profits than other corporations.  (For source of net profit information see YCharts.)

The Federal Government is a Monopoly

Of course, when gas prices go up we tend to feel that more than other commodities.  Because we use a lot of gas in our daily lives.  Which leaves us less money in the wallet to buy those other commodities.  Which are more expensive because of the higher energy costs to bring these other commodities to market.  Few things affect prices like energy.  And oil is the big player in the energy market because it is the energy of choice in transportation.  Ships, planes, trains and trucks all use oil-based fuels.  And no matter how green we get this isn’t going to change.  Because there is no other portable fuel with such a large energy content available.  And won’t be in the conceivable future.  You just aren’t going to replace any of these with electric versions.  And that’s just not in the U.S.  It’s in all of the advanced and emerging economies in the world.

This is why oil prices are going up.  It’s not the greed of a small cartel of oil producers.  It’s the exploding demand.  And the high oil prices are allowing these companies to bring oil to market that was simply impossible a decade or two go.  And there’s more oil out there.  But we have to get it out of the ground.  And we need to be doing this some 5 years before we need it.  Because it takes about 5 years to bring new oil onto the market.  And they would be drilling exploratory wells like there is no tomorrow in the U.S.  If it wasn’t for the hurdles they have to jump through to get a permit from the government.  An oil company can spend 5 years or more in the permitting process.  They can spend millions of dollars in the process.  And yet the government can still deny them the permit.  Without any compensation for their investment to date.

This isn’t unique to any one oil company.  They all go through this.  It is very difficult indeed to start drilling a new well in the U.S.  Which means it costs more to drill a well in the U.S.  So some oil companies eventually give up and go elsewhere to look for oil.  Taking with them good oil jobs.  Which reduces domestic oil supplies.  Making us more dependent on foreign sources of oil.  Which increases the cost of oil-based fuels in the U.S.   But it’s not any oil cartel doing this.  Although it is a monopoly.  It’s the federal government.  The oil companies will still go out there and find oil and bring it to market.  It’s what they do.  They just don’t do it here.  Because the U.S. government just makes it too difficult to do this in the U.S.

Getting Oil out of the Ground is not Easy

Only the power of government can interfere with the free market.  Because it takes legislative authority to restrict the free market.  Create cartels.  And monopolies.  It’s not one big oil company keeping the others out of the U.S. market.  It’s federal regulation keeping all of the oil companies out of the U.S. market.  And this is what is increasing the price at the gas pump.  And in commodity prices across the board.  Because the high oil prices are just begging for them to come in and find oil and bring it to market.  Even in sources once considered too costly (oil sands, deep wells, arctic climates, etc.). 

And just like every business has competition, so do markets.  Getting oil out of the ground is not easy.  It is a very costly and speculative industry.  And as oil becomes more costly to bring to market, fewer are able to do it.  You need deep pockets.  And deep experience.  Those who can and do so at a profit are in great demand.  So if they can’t drill in the U.S. they can drill someplace else.  And do.  Because of the big U.S. monopoly, the federal government, has shut them out of the U.S. market. 

But as people look forward to the summer driving season, they will curse Big Oil.  Not the federal government.  Even though the former fights to bring oil to market.  While the latter fights against it.

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