Doubtless, you have noticed rising oil prices. At closing today, a barrel of light sweet crude oil was selling at $105.15 on the New York Mercantile Exchange. In my neighborhood, this translates to a price of $3.15 to $3.25 a gallon for unleaded gasoline. Diesel was priced at $3.95 a gallon at a gas station I passed today. In fact NPR reported today that gasoline is now more costly in constant dollars than it ever has been, including during the first Arab oil embargo in the 1970s.
Some investors are seeing crude oil as the new inflation hedge. An NPR analyst estimated that these investors are driving up the cost of oil by about $20 a barrel. Whether their investment will be the inflation hedge they are looking for remains to be seen. These investors may be fooling themselves. At some point, oil may become so overvalued that the price of oil returns to what now seems like reasonable levels, $80 a barrel or so, or even less. I will not shed too many tears for these speculators, but $80 a barrel oil still strikes me as expensive, since it typically results in gas prices of about $2.60 a gallon.
One thing is clear, as these graphs in today’s Washington Post point out. A good portion of the cost of oil is not because the commodity is in greater demand, but because its price is tied to the price of the dollar. If the demand and supply of oil are relatively constant as is currently the case and the value of the dollar diminishes, oil will cost more dollars per barrel.
In case you have not paid attention, the U.S. dollar is reaching record lows too against most major currencies. Last September for the first time since 1976 when we were in the midst of a stagflation epidemic, the Canadian dollar and the U.S. dollar were worth the same amount. Oil prices went up 75.6% since the beginning of 2007, according to the Washington Post. Because the Canadian dollar is in better shape than the U.S. dollar, oil prices went up a more modest 46.6% in Canada. If you bought your oil in euros, prices rose 49.6%. The price of our relatively weak currency means that we pay considerably more for oil than some of our closest trading partners with better-managed governments and economies. As you can imagine, we pay extra for many other things because of our fallen dollar. Oil is an easy one to quantify because it is tied directly to the dollar.
Perhaps you are thinking that our government is doing something to stem the drop of the dollar. If you think this, you are sadly naïve. No, the situation is quite the opposite. Ben Bernanke, the Chairman of the Federal Reserve, told Congress recently that the Fed would drop interest rates again to stimulate the economy. This will undoubtedly drive the dollar even lower. It will also put more upward pressure on the cost of oil and cause inflation to rise, likely adding to the likelihood of the stagflation we saw in the 1970s. In addition, sometime around May you will get a fat check from the government. The government wants you to go out and spend the money to stave off a recession that looks like it arrived in the end of 2007. Where is the money coming from? The government is borrowing it. Who is loaning their money to the government? While many of us do this by buying bonds and treasury bills the bulk of this money will come from foreign governments and creditors. To make sure we have the money now we will raise interest on U.S. treasury bills until it becomes worthwhile for creditors to buy all the bonds we need to sell. Not surprisingly, rates on treasury bills are up.
When the time comes to pay creditors for loaning them their money, the government will not pay them in assets like military aircraft or wheat surpluses. No, it will pay them off in dollars. The problem is that the government has no spare dollars sitting around in a teller’s drawer to give them. The government will not hold up an investment group like Vanguard Securities until they cough up $100 billion. Instead, they will print more money. They are doing this today to pay off creditors who bought securities years ago. Because the economy is not growing fast enough to keep up with our spending, this means there is more money in circulation chasing the same relative assets. Creditors know what this means: their investment is worth less. Thus, the dollar loses value against other currencies and investors require higher interest rates. Prices for everything become comparatively more expensive but the effect is worse for prices pegged to the dollar, like oil.
In short, deficit financing drives down the value of the dollar and is inflationary. Granted sometimes it is hard to tell. When the economy is doing well it may seem that there are no inflationary effects from deficit financing. This is an illusion. Of course, there are times when you have to borrow for an important need. I borrowed money recently to replace the windows on my house. I did receive some value from it. My house is much more energy efficient, our rooms are less drafty and we use fewer kilowatt-hours of power. Unlike the government, I have been paying off my debt. The way our government works, it only very rarely pays down the principal. Instead, it keeps borrowing more and more money. All that matters is whether the government can meet its interest payments. If it can, creditors keep loaning us money. As Dick Cheney reputedly said, “Reagan proved that deficits don’t matter.” Oh, but they do. They do.
While there were many reasons for the prosperity of the 1990s, I think that it was mostly due to the government living within its means. Steadily decreasing deficits gave investors confidence that government was being run by rational people. No recession stimulus could provide that kind of boost. Like a savings account, the interest started compounding, resulting in true wealth that affected all income levels.
If we can stop our addiction to deficit spending, real prosperity is likely to reemerge. However, it will not be easy. Deficit spending cannot be cured by trimming the fat in a few government departments. I do not believe we will have real prosperity again until we end our War in Iraq. It is paid by foreign creditors, many of whom do not have our best interest at heart. It is like a chest wound to the national body. We are losing a lot of blood. We must stanch the wound. Waging a hundred year war, like John McCain has suggested, will simply bankrupt the country. If the country is bankrupt then in some way the terrorists have won because whatever is left of our country will sure not resemble the America we know today.
We should not throw good money away on a bad investment. Iraq not only a bad investment, it is increasing your costs of living. The Iraq War costs us about three billion dollars a week. Those are the short-term costs; the long-term costs of the war are truly frightening. When you factor in costs like caring for our disabled soldiers, paying interest on the debt (but never the principle) the real cost of the war will reach at least three trillion dollars.
If you think you are not already paying a war tax, you are mistaken. If you are applauding President Bush for not raising taxes, you are naïve. You pay the war tax every time you go to the gas station and fill up your gas tank. You pay it in $3 a gallon milk. You pay it in high credit card interest rates and in huge tuition costs. You pay it every day but you do not necessarily associate these costs with the war because the money is not going through the U.S. Treasury. The falling dollar and the inflation it brings is the price of a country living way beyond its means. It is the price of financing a war that we cannot afford but chose to start anyhow. These indirect taxes though do not buy you any additional prosperity. It goes to oil companies and foreign governments, many of whom we do not like. In fact, much of this war tax simply provides the financial means for us to become embroiled in more wars, because we give the money to states that do not like us. It gives them more capital to carry on their animosities. This money does not build new bridges. It does not improve the educational standards of Americans. They are in effect squandered dollars, and squandered wealth — your wealth.
We will leave Iraq and sooner than we think simply because we cannot afford to finance it must longer. What point do gas prices have to reach for us to pull the plug? My guess is about four dollars a gallon. Perhaps at that threshold we will reach national consensus and end this pointless and foolish war.