Tuesday, March 8, 2011

Gas prices, Obamanomics, and the return of inflation

Drivers around Atlanta have undoubtedly noticed rising gas prices over the past few weeks.  Georgiagasprices.com reports that the average price of regular unleaded gasoline in Georgia is $3.428, just below the national average of $3.487.  Georgia’s average price has risen 42 cents per gallon in the past month and 78 cents in the past year.  This is an even sharper increase than the national average which is up 36 cents in the past month and 74 cents in the past year.

Part of the reason for the increase in gasoline prices is undoubtedly the unrest in the Middle East.  Whenever there is political instability in oil-producing regions of the world, which is fairly often, the price of oil tends to rise.  This, in turn, causes the price of gasoline and other items made from oil to rise.  The problem is compounded by the Obama Administration’s attempts to stop new domestic oil exploration and the EPA’s new carbon regulations

The rising price of oil may both mask and contribute to something more insidious as well:  a return of inflation.  Rampant inflation and resulting stagnant economic growth characterized the entire decade of the 1970s.  The inflation of the 1970s was caused by many of the same factors that are present in our economy today.  President Nixon ran up federal deficits and imposed wage and price controls.  Along with Federal Reserve Chairman Arthur Brooks, Nixon also increased the money supply sharply in an effort to end a recession and reduce unemployment.  Further, oil prices spiked twice in the 1970s as well; first, in 1973 with the Arab Oil Embargo and again in 1978 with the Iranian Revolution.

These factors are mirrored today in President Obama’s economic policies.  The federal deficits under Obama have led to an increase in the federal debt of $3.5 trillion.  Obama has also launched controls in some areas of the economy.  The president capped the pay of Wall St. CEOs of companies receiving federal bailouts.  He has also openly considered the idea of price controls as a remedy for health insurance costs that are rising even more sharply in the wake of the passage of Obamacare.  Federal Reserve Chairman Ben Bernanke is currently increasing the money supply by printing money under the guise of “quantitative easing.”

It is axiomatic in economics that as supply increases, price decreases.  Therefore, we can predict that as the supply of dollars increases through quantitative easing, increasing the money supply, that the price (or value) of those dollars will decrease.  Essentially this means that as the government prints more dollars, each individual dollar is worth less. 

Already, the specter of inflation is rearing its head in world markets.  One of the most notable areas of price increases is in world food markets, where food prices are at the highest point since the UN started tracking them in 1990.  Ironically, the rising cost of food in poor Arab countries may have been partly to blame for the outbreak of revolts against Middle Eastern dictators.  The unrest then further drives up oil prices, which leads to more inflation. 

President Obama with Fed Chairman Ben Bernanke
Bad weather and crop failures around the world have contributed to rising food costs, but economists believe that government mandates to use more food for ethanol production instead of consumption also play a major role in rising food costs.  Economics teaches that when something becomes more scarce, as when food is diverted to manufacture ethanol, it becomes more expensive. 

At the same time, ethanol remains uncompetitive in spite of government subsidies.  A plant in Soperton, Ga. that produced ethanol from wood recently shut down in spite of receiving over $150 million in government loan guarantees and grants, while a corn ethanol plant in Camilla, Ga. is in bankruptcy.  Ethanol subsidies and mandates are detrimental in that they add to the federal deficit while also driving up world food prices.

The Consumer Price Index (CPI), which measures inflation, has been relatively steady.  The CPI, however, does not typically include food and energy.  When food and energy prices are included, the CPI shows a sharp uptick in recent months. 

A further indication of the onset of inflation is the rising price of gold and silver.  Precious metals, gold in particular, are often considered a hedge against uncertainty and inflation.  After falling with the economy in 2008, the price of gold has rebounded sharply.  Since President Obama took office in 2009, the price of gold has risen from less than $900 per ounce to $1,467, an increase of more than 60%.  Silver has reacted even more dramatically, rising from just over $9 per ounce to $35, an increase of almost 300%.

Many economists do believe that monetary policy is the sole cause of inflation and that rising oil prices are a symptom of inflation, rather than being one of its causes.  In this case, rising oil prices are still bad news for the U.S. and world economies.  There is a strong link between spikes in oil prices and recessions.  The typical pattern is that oil prices increase dramatically, at least partially causing the recession.  As the economy slows, demand for oil decreases, which leads to a decline in the price.  This often allows the economy to rebound. 

This is the pattern followed in 2008 when record high gas prices were experienced just prior to the financial collapse.  After the onset of the recession, oil and gas prices dropped dramatically.  The Obama Administration’s regulatory and financial policies postponed the recovery and kept oil prices low until recently.  As the economy slowly recovers, oil prices would normally start to creep upward again.  The unrest in the Middle East provided more upward pressure as well.

Algerians riot over high food prices in 2009 (Flickr: 110109 Algeria slashes food prices amid riots)
In the current economic climate, the Federal Reserve is dramatically increasing the money supply.  At the same time, political unrest in the Middle East and Obama Administration policies at home are driving up the cost of oil and energy.  Problems with crops and diverting agricultural resources to ethanol production are increasing the cost of food as well.  If these trends continue, Georgians can expect gas prices to continue to rise, along with the prices of milk, bread, meat and other foods.  Eventually, if left unchecked, inflation will spread to other areas of the economy as well.

The cure for runaway inflation is almost as bad as the disease.  The rampant inflation of the 1970s was defeated only by the strategy of Ronald Reagan and Federal Reserve Chairman Paul Volcker to tighten the money supply (by increasing reserves of central banks and reducing the supply of money in the economy).  This strategy led directly to the recession of 1980, but ultimately inflation was defeated and the economy entered a strong recovery.  Other policies that President Obama is unlikely to embrace, such as tax cuts and reducing regulation, helped to ease the transition to tighter monetary policies.

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