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The Adjustment Process to Global Inflation

June 30th, 2008 · No Comments

In a previous entry we wrote about the paradoxes of the global inflation problem and how the US, in the worst economic condition to deal with it, shares most of the adjustment problem. Here we expand on the theme and argue that markets, not policy makers, will do most of the adjusting.

Here is an example from Jeff Rubin at CIBC:

Over the next four years, we are likely to witness the greatest mass exodus of vehicles off America’s highways in history. By 2012, there should be some 10 million fewer vehicles on American roadways than there are today—a decline that dwarfs all previous adjustments including those during the two OPEC oil shocks.

There is a simple economic law called the law of diminishing marginal utility, coined by Gossen (expanding on ideas first expounded by Jeremy Bentham, if you must know). It basically argues that consumption will reach a point at which another item of something will provide less utility than the previous (even for collectionists or an addicts).

This may sound rather abstract, but it’s one of the most important laws in economics, as it establishes a negative relation between the price of something, and it’s demand. Now, that relation might not be very strong, that is, there are goods for which even large price rises will not significantly dent demand. Demand is said to be inelastic.

But if price rises are large enough, and adjustment time is allowed to gather, adjustment will happen. Rising gasoline price will have that effect, especially in the US because

  1. Energy efficiency overall, and in particular of cars, has not increased in the same way it did in other advanced economies (Europe and Japan)
  2. With half of the world’s population never having to pay world oil prices, it shouldn’t come as a great surprise that $130 per barrel crude prices have yet to quash world demand. (Rubin)

So, not only do policy makers have to make the largest adjustments in the US, but US consumers will also bear the brunt of necessary adjustment.

Insofar the car market has not completely plunged as a result of the economic problems, people are switching to more fuel efficient cars (there is a world to win on this front) and are driving less. This matters, seriously.

It has been calculated that in the US the price elasticity of oil is around 16%. For gasoline, it’s actually higher (around 20%, as in March, when the price rose by 21.5% but the amount of kilometers driven was reduced by 4.3%), but for other energy consumption, it’s lower.

If this figure is extrapolated for the whole world, it would mean that if oil would rise to $200 per barrel, demand would be reduced by 12 million barrels a day (from 87 to 75M barrels). Now, unfortunately, American demand elasticities cannot be extrapolated to the rest of the world as in many countries energy prices are kept artificially low, reducing worldwide demand elasticity.

China, where demand is rising fast, is one of these countries. China made some modest inroads in increasing the unrealistically low energy prices domestically (these prices are set administratively), which will reduce demand, somewhat. But since the US is still the world’s most energy  hungry country by far, reduction there would matter, and this is already happening.

And this is looking at the oil market from the demand side only, for sure, there would also be a supply reaction to high oil prices, new, previously uneconomic resources will be put in production, others will be discovered, so more energy will be produced over time as well. Alternative energy will get developed faster.

High energy prices would, albeit slowly, reduce demand and increase supply. Market adjustment is a wonderful thing. Which is actually amounting to say that we’ve already seen the biggest increases in oil prices.

Prices of $200 per barrel (only another 40% up from here, after the price has six folded in the last year and a half or so) would almost certainly not be sustainable. So, if policy makers do not make terrible mistakes (in terms of adding to inflationary pressures through monetary and/or fiscal policies), inflation will be kept under control.

At least it’s possible.

Tags: The Markets