Senator Obama is on a vist to the Middle East and Europe.   Senator McCain went to visit Colombia earlier in July.   These trips suggest a seriousness of purpose that American presidential candidates often lack.    They offer us hope that the candidates want to learn how to do the job well.   Furthermore, they offer a hyper-attentive world grounds for hope that the next president will have a higher level of interest in other countries than did his predecessosr.

So far as I know, it is unprecedented for the two party candidates to do foreign policy trips before the election.    I can think of three reasons why we are seeing this now.    First, because the primary elections started early this year, there is a hiatus between the end of the primaries and the party conventions.   Thus the candidates can spare the time to go abroad.   Second, foreign policy has risen much higher on the agenda of concerns of typical American voters, since September 11, 2001, and since the invasion of Iraq.   (And of course Obama wants to put to rest McCain’s past jibes about not having visited Afghanistan and Iraq.)   Third, Barack Obama and John McCain are not the usual inward-looking, domestically-oriented parochial governors that we all too often get as presidential candidates.    Both are US Senators, and both in their youths had very formative adventures in foreign countries (both in Southeast Asia, as it happens).    Thus both, if nothing else, have the cosmopolitan outlook that a world leader needs.

Traditionally new presidential candidates do not think much about foreign policy during their campaigns.  This is especially true of governors who have only domestic experience.   But, regardless of the candidates, in most election years the American public cares little for international affairs, and is far more concerned about domestic issues.

Once new presidents take office they ften have to go through a period of “breaking in” in the area of foreign policy.   International events often take them by surprise and disrupt all their fine platforms and plans.  This period can be very costly to the country.   Think of John Kennedy’s first-year failures in his initial summit meeting with Premier Khrushchev and in the Bay of Pigs invasion.   Think of George W. Bush’s first-year failures in ignoring warnings that Al Qaeda would strike in the US or that an invasion of Iraq would be fraught with danger.    A little international exposure before they took office would have served them well.  So perhaps the excessive length of this election cycle has a silver lining after all !

Someone this week asked me what I thought of policy-makers who ex ante profess a free-market ideology and acute sensitivity to the dangers of moral hazard from financial bailouts, but who toss that ideology overboard when faced with a financial crisis.  The reference was to Treasury Secretary Henry Paulson’s lobbying this week in support of a rescue for Fannie Mae and Freddie Mac, the two big home mortgage agencies, following on the rescue of Bear Stearns in March.   My reply was:  “They say there are no atheists in foxholes.   Perhaps, then, there are also no libertarians in financial crises.”

There are more egregious cases than Hank Paulson of inconsistencies between ex ante promises by policy-makers not to bail out and ex post bailouts when disaster strikes.    (Indeed, some amount of change in position may even be rational for an office-holder, though I would draw the line at false statements.)    I reserve my disdain for those who go around lecturing others on the evils of bailouts, only to out-do the officials they criticized when their own turn in the hot-seat comes.  

An example I have in mind concerns the members of the starting team in the Bush Administration who had lectured the Clinton Administration on the evils of its allegedly excessive bailouts of emerging markets in the 1990s, only to engage in worse when they themselves were faced with the Argentine crisis that began in 2001.  There was no particular reason to rescue the Kirchner government.   Argentina in 2003 would have been the perfect place to refrain from rolling over an IMF program, thereby putting a limit on the moral hazard problem.   The Clinton Treasury had done this with Russia in August 1998 despite high costs in terms of systemic contagion.   Yet the Bush White House continued to push the IMF to bail out Argentina.  Apparently the failing lay in simple inexperience and lack of awareness that any such choices are always difficult.   (See pages 9-11 of my article on Managing Financial Crises, in the Cato Journal, Summer 2007.)    The Administration was very much following in the footsteps of the Reagan Administration, which talked tough at first when the international debt crisis hit in 1982 but which then participated in comprehensive IMF-led bailouts of Latin American debtors who had been pursuing far worse macroeconomic policies than the emerging market governments of the 1990s crises.  

Incidentally, before writing this blog post, I checked into the World War II origins of the sentence “There are no atheists in foxholes.”     I discovered to my surprise that this expression was intended, and is still considered, as a put-down of atheists, and that their lobby protests its use.  

Of course the proposition is not literally true; indeed some soldiers lose their pre-existing belief in God when confronted with the horror of war.   But let us stipulate that those who suddenly face death more often find religion than lose it.  What strikes me as odd is that the expression is apparently normally interpreted as meaning that people who profess atheism don’t really mean it, and that their true colors come out under pressure.     I had, apparently erroneously, thought rather the reverse.   (Indeed, Richard Dawkins argues that vast numbers of people who would no more bet on the existence of God than on the existence of the Easter Bunny, nonetheless call themselves “agnostics” rather than atheists, to avoid rocking the boat.)   

I had always taken the expression to mean that mankind’s hunger for religious beliefs comes from a desperate desire for divine intervention – or, failing that, comfort – when confronting death.  Something more along the lines “There are no unsoiled underpants in foxholes.”     I am in sympathy with the character in a novel who said “That maxim, ‘There are no atheists in foxholes,’ it’s not an argument against atheism — it’s an argument against foxholes.” 

So what’s my point?    Not to argue that governments should intervene always  (nor that they should intervene never).  The lesson for government officials is that wherever they choose to draw the bailout line – one hopes the line strikes an intelligent balance between the short-run advantages of ameliorating a serious financial crisis and the longer-run disadvantages of moral hazard — they should think through the system ahead of time.  They should take the appropriate regulatory precautions during the boom times, which correspond to the bailouts that will inevitably come during the busts.   

Long ago, the United States worked out the approximate right answer for banks:  there will always be rescue of small depositors ex post when banks run into serious trouble, and so under our system, (i) deposit insurance provides formal guarantees ex ante and (ii) banks must pay the price ex ante through reserve requirements, capital requirements, and active regulatory oversight.  What we now need to do is design the analogous sort of system for non-banks.

It should not come as a surprise to high officials that there are such things as financial crises anymore than it should come as a surprise to soldiers that there are such things as bombs.   Human nature must be accepted for what it is.   But in the case of  high officials, it shouldn’t be necessary for them to alter their fundamental beliefs when crisis strikes, in the absence of truly unforeseeable developments.

President Bush yesterday eliminated a 27-year executive moratorium on off-shore oil drilling (NYT, 7/15/2008, p.A13), a move also supported by presidential candidate John McCain. 

The Democrats responded:

(1) that this was an election-year stunt,

(2) that the move would be too small to make a difference

(3) that it would bring no downward pressure on oil prices at the crucial short-term horizon, and

(4) that it would not ultimately help move the country in the direction of energy security.  The Democrats have the right answer, but are giving the wrong reasons.

No doubt they are right that it is a political stunt.  A Congressional ban on offshore drilling has been in effect since 1981, so the President’s action is moot.  But making a political point in this way is in itself fair game.  The Republicans are trying to blame high oil prices on the Democrats.   Similarly, the Democrats’ response could well be the right one from the viewpoint of political gamesmanship.

But I should try to stick to economics in my blog, rather than politics.  The issues can be slippery; but let’s take the bit in our teeth and drill down on what would make for good for policy.

On grounds of good economic policy the Democrats’ chosen arguments seem to me beside the point.  It is true that the oil in the offshore sites would add up to “only a few months of national consumption.”  It would not amount to much as a percentage of world reserves, which is the relevant metric for determining the effect on price.   But if one believed there was no cost to more domestic oil drilling, then one should conclude that every little bit helps.  Basic economic theory tells us to judge proposals by the ratio of benefits to costs, not by the absolute magnitude of the benefits.

Regarding point (3), both parties are responding (unsurprisingly) to the American public’s great sensitivity to short-term prices for gasoline (in the summer) and home heating oil (in the winter).  No doubt high prices are causing a lot of hardship.   (And even if it takes five years to develop new oil reserves, the knowledge that the oil was coming should put a bit of downward pressure on prices today.)   But market prices are high today for a reason.   What is the market failure that would call for government intervention in the oil market?

The most obvious market failures are the externalities that characterize air pollution and emission of greenhouse gases.  These of course are reasons for higher prices, not lower.   I am struck every time I see an article on politicians’ commitment to action on global climate change sitting side-by-side in the newspaper with an article on their opposition to oil price increases. 

I realize that higher energy taxes are politically out of the question at this point.   But I could imagine legislation that would automatically raise energy taxes if and when oil prices fall, thereby putting a floor at recent levels and providing industry with the clear incentive to undertake the long-term investment in energy-saving equipment and technology that we badly need.  Rebate the proceeds by fixing the AMT, or removing the payroll tax on low-income Americans, one answer to the income distribution point.  In any case McCain’s proposal for a gas tax holiday is a spectacularly bad idea.

The other obvious market failure that might justify government intervention in the market is national security, and here we come to argument number (4), and the central point of my post.  While Americans need to recognize that achieving complete energy security is an impossible goal, it should indeed by a national objective to reduce our dependence on imported oil.  We could thereby reduce our need to fight messy wars in the Mideast and to coddle unpalatable autocrats worldwide.  But, in the first place, conservation is the largest and most sustainable component of such a strategy.   In the second place, as high as world energy prices are now by historical standards, this is not the worst-case geopolitical crisis that we should be seeking to protect our economy against.  That worst-case scenario is a prolonged loss of world access to Gulf oil stemming from some combination of military conflict with Iran, anti-Western popular uprisings in the region, terrorism, and/or nuclear or radiological weapons. 

Once the long-term goal of “energy security” policy is properly seen to be amelioration of the economic effects of such a disaster, the Republican policy of “drain America first” is seen to be precisely the wrong response.  We don’t want to maximize current domestic production.  Rather we want to leave the oil underground (or underwater) for decades, until we really need it, until we are so desperate that the economic benefits really do outweigh the costs.  (The costs are chiefly environmental, of course.  But the Republicans have often been keen on giving oil companies access to nationally owned reserves at prices that are even below market costs.   Same as hard-rock mining for mining companies, subsidized water for farmers, and grazing rights on federal lands for ranchers.  But the hypocrisy of the self-reliance rhetoric in Western states — “get Washington off our backs” –  is another story.) 

Thus the Democrats have it precisely backwards.   The problem with Republican proposals to re-open domestic oil drilling is not that we desperately need the oil right now, whereas new oil discoveries would not come on line for 5 to 10 years.   Rather it is that we might truly desperately need the oil in 20 or 30 years, and so don’t want to use it up over the next decade.

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The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser).   It makes sense.  The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.  The economic dynamism — most striking in Dubai –  is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating.  Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers.   An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies.   This would be an improvement.   Kuwait, for example, made this switch a year ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be.    Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be.   A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks.  But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. 

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor.  But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg.   I have laid out the case elsewhere (including also for the case of Iraq).  I call the proposal PEP, for Peg the Export Price.   I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

 If you wish to post comments please go to the RGE version.   

Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week:

I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog.

A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter).

However, there are many places in the world where inflation expectations are not well anchored. Or at least we can’t tell if they’re well anchored or not. Figure 1 presents data for several key groups (using the IMF classifications): Industrial countries, LDCs excluding oil exporters, oil exporters and developing Asia.

Figure 1: Inflation rates defined as 12 month changes in CPIs, in selected groupings: Industrial countries (blue), oil exporters (black), developing countries excluding oil exporters (red) and developing Asia (green). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

It’s clear that inflation is surging in the oil exporting countries. This is occurring as reserves balloon (see Brad Setser has diligently tabulated on a number of occasions; e.g., [1]), often under pegged-to-the-dollar exchange rate regimes, and the monetary authorities are unable to sterilize money base expansion. Here, I can’t resist writing the identity:

Money Base = Foreign Exchange Reserves + Net Domestic Assets

As foreign exchange reserves increase, money base must increase, unless the central bank can (and will) sterilize by making offsetting reductions in net domestic assets.

This is why Feldstein has called for de-pegging from the dollar for oil exporter currencies [2] (for contrasting recommendations, see Paulson’s comments [3]).

Of course, this mechanism does not apply in all instances, there are oil exporting countries not under fixed exchange rates, but reserve accumulation nonetheless is making its way into money base creation. As government revenues increase, spending is also pushing up prices.

So, no surprise that inflation is rising in this group. But what is surprising is how much inflation has risen in the non-oil-exporting LDCs, and in Developing Asia (this group excludes NICs like Korea).

Figure 2: Inflation rates defined as 12 month changes in CPIs, in selected East Asian countries: China (red), Malaysia (blue), Philippines (green), Thailand (black), Vietnam (teal). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

Inflation has risen as food and energy prices have risen. Vietnam is the most striking example. And China, of course, has been in the spotlight, largely because of its economic mass. But note how Thailand and the Phillipines inflation rates have accelerated.

Now one might say this is all obvious - - but in several of these countries (e.g., China), energy prices were heavily subsidized. Raising these subsidized prices will - - in a mechanical fashion - - raise the recorded CPI. If prices were perfectly flexible, higher energy and food prices only represent a higher relative price for these goods. I’ll let the reader determine for him or herself whether that’s a plausible assumption. In any case, the net effect over the longer term is uncertain. Raising the subsidized prices means higher prices on those specific goods (possibly feeding into wages). But the lower government outlays for subsidies means smaller deficits (holding all else constant) and hence lower money base creation.

Is there hope to be derived from the fact that there are more inflation targeters now than there were during the previous episode of inflationary pressures, three decades ago? In a paper written two and a half years ago, Andy Rose documented the fact that inflation targeting has proven to be a relatively durable form of monetary regime. That is, compared to the “fixed” exchange rates, an average duration of an inflation targeting regime is longer. One observation I would make is that most of those inflation targeting regimes were implemented in a relatively benign global economic environment - - at least benign from the inflationary standpoint. While oil prices have been rising since 2002, it appears that the surge in food prices, on top of oil and non-food commodity prices - - is what has changed matters (Figure 3 recaps a graph from this post).

Figure 3: Log indices. NBER defined recession shaded gray. Source:.
(Of course, these oil and food price shocks may end a lot of exchange rate reimges as well).

By the way, Thailand and Philippines are classified as inflation targeters by Rose. Korea, also classified as an inflation targeter, has also experienced accelerating, but nonetheless lower, inflation (at about 4 percent). So, the jury is still out on the question whether the commitment to inflation targeting during this episode will result in a substantive difference in how matters play out.

On a more speculative note, one idea that has struck me is that, as inflation rates rise, it may become more difficult for the East Asian countries to maintain their exchange rates against the dollar at their current levels. Recalling (in logs):

q^j = s – p^j + p ^US

In words, the real exchange rate for country j against the USD (defined as up is weaker) will strengthen as the domestic price level rises, holding all else constant. That may in turn a be a harbinger of the end of the tendency for the East Asian countries to export capital to the US (although the overall US current account balance will tend to remain driven largely by domestically driven by the saving/investment balance in the US, and we know where the current trajectory of the US budget deficit is going…[4]).

Figure 4: Trade weighted broad real currency values, in logs. NBER defined recession shaded gray. Dashed line is at June 2005, the month before the CNY revaluation. Source: BIS accessed June 23, 2008.

So far, this remains speculation. However, over the past couple months, China’s real currency value has appreciated in trade weighted terms, which is remarkable when one keeps in mind the dollar’s depreciation over this same period. It remains to be seen whether the other currencies follow suit. That may hinge upon how these countries respond to inflationary pressures.

Since I started this blog, my comment section has been inundated with spam.   I am not talking about bona fide comments, most of which have been intelligent and useful.   I’m talking about thinly disguised bids for sales of pornography, mortgage quotes, and other parasitical activities.    The spam has reached 35 per night, and it is time-consuming to go through it all.  For some reason I don’t understand, my software can’t  filter it out, even though other bloggers don’t seem to have this problem.

Hence, reluctantly, I am turning off the comment function on my blog site.    I am sorry about this.  Most of my posts will be carried by Roubini Global Economics from now on (though possibly with a slight delay).  Readers who have access to RGE may post comments there, and I will check periodically.

Over the past month, I , citing Feldstein, have said that if one looks at available information on monthly GDP, available from estimates of MacroAdvisers, that output declined within the first quarter of the year, even though as standardly reported GDP was higher in QI overall than it had been in the last quarter of 2007. But, as it turns out, there is some ambiguity to the question.

The estimates do show GDP falling in February, by a hefty 10.1% anualized. But the numbers for January and March are up. To net out the three months, one must split hairs. The positive numbers for January plus March are just slightly greater in absolute value than February’s negative 0.9 (monthly). So the net is up? Not necessarily.

We are trying to figure out the change within the quarter, from beginning to end. Technically, that means from January 1 to March 30. But of course even Macroadvisors doesn’t report daily or weekly estimates. Estimated total real GDP in the month of March was just slightly above total real GDP in the month of December. So again the net is up? The most precise measure of the change between January 1 to March 30 is the change between the December-January average and the March-April average. That is a tiny negative number: GDP fell by an estimated $28 billion within the first quarter (in year-2000 $). And April is so flat as to be essentially zero.

I think I am sorry I brought the subject up.

It would in any case be a mistake to make much of these numbers. The reason the Commerce Department’s Bureau of Economic Analysis doesn’t report monthly numbers is that the data are so unreliable, and subject to revision. For anyone who needs some sort of estimate of monthly GDP, as we do on the NBER Business Cycle Dating Committee as an input into our thinking, this is what we have to go on. But one sees here yet another illustration as to why the BCDC waits a long time, until all the data are in, before declaring a recession.

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Everyone is looking for someone to blame for high prices of oil and other mineral and agricultural commodities.    Speculators (among others) are high on the list, followed by the Federal Reserve.    While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of channels.  Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices.

A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low.    It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

US crude oil inventories do not appear to be especially low in the graph above, showing June 1998-June 2008 (from Bloomberg).  But it is true that they are not especially high either.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most.     According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows.  They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place.  These numbers are far from conclusive, but still…

The theory is meant to explain the mystery why prices of virtually all mineral and agricultural prices are high, not just oil, and in some ways fits others better.     Inventories of some commodities are indeed high now.   The price of gold, the last graph shown, is a good example.   Here the evidence supports the theory (1) that easy monetary policy has driven up the price, and (2) that one channel is low interest rates making it more attractive to stockpile the yellow metal.   But, as with oil, the biggest inventory is the one underground.

[Thanks to Pravin Chandrasekaran.]

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The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is about to enter a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the early part of the year, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain:
1) The number will be revised again, and could move in either direction.
2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse later in the year.
3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. Real gross domestic purchases increased only 0.1 percent in the first quarter — almost as flat as you can get. But net exports provided an important source of demand for US products, and are likely to remain a positive engine of growth in the future. The same is true of the fiscal policy engine, as consumers receive and spend their tax cuts in the 2^nd and 3^rd quarters. On the other wing, the investment engine has been knocked out; inventory investment is likely to fall and residential construction will remain negative for sometime. The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years? If so, a recession will ensue.

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together:
(1) the odds that it will turn out that we have already passed the turning point and
(2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year.
Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Fed Vice Chairman Donald L. Kohn in a speech yesterday, addressed a theory to which I am partial: the theory that low real interest rates have been a factor behind the continued rise in prices of agricultural and mineral commodities, including oil, over the last year.

The relevant excerpt: “Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.” (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth. (See graph, where the commodity price has been inverted so that one can see the correlation visually.)

The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.

Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.

Stocks of oil held in deposits underground dwarf those held in inventories above-ground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation as apply to inventories. (The classic reference is Hotelling’s Rule.)

Apparently the Saudis have indeed deliberately decided to leave theirs in the ground. “King Abdullah, the country’s ruler, put it more bluntly: “I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it’.’’ FT 5/19/08. I see the interest rate as part of the Saudis’ decision how much oil to pump. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today’s oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.

In addition to the link from world real interest rates to world real commodity prices, there is the less novel link from individual countries’ real interest rates to commodity prices expressed in their own currencies, a link that primarily passes through their exchange rates. For almost all of the eight floating-rate countries that I tested, both the US real interest rate and the local real interest rate (as a differential relative to the US rate) simultaneously had significant effects on real commodity prices. The effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly. This despite what many have thought in the past, that there is little effect because oil is invoiced in dollars.