TCS Daily

The Dollar Factor

By John E. Tamny - June 14, 2004 12:00 AM

The recent spike in oil prices has predictably led to lots of finger pointing as to the cause. China, just six months ago thought to be the source of falling prices around the world, is now miraculously being blamed for higher prices, too.

USA Today's editorial page cites "spectacular growth in emerging markets, particularly China," in explaining expensive gas prices, as does the International Energy Agency ("the 'China factor" has more bearing on oil prices than any 'risk factor'"), and Naomi Fink of BNP Paribas who says "we are seeing demand-driven price increases."

The above reasoning might surprise consumers in Europe and Japan. Indeed, according to Trend Macrolytics chief economist Donald Luskin, the Euro price of oil greatly resembles the one from 15 months ago. Boston-based H.C. Wainwright Economics has done a similar study, and it turns out the Yen price of oil from 15 months ago is actually higher than today's.

Since there's no evidence that Japan and Europe are sold oil at massive discounts to the U.S. dollar price, the explanation for rising prices in the U.S. logically cannot be China. The answer is pretty simple though, and would be especially obvious to those who have watched the dollar's fall against the Euro and Yen over the last couple of years. This isn't to say that demand plays no factor in the oil price, just that it is small compared to local currency effects.

Looked at historically, this should not be surprising. If demand actually did play the major role that commentators are presently ascribing it, one would certainly assume that oil prices were really high in the late '90s. The U.S. economy was booming, not to mention that China was enjoying the 9% plus yearly growth that began 25 years ago, and continues to this day. Despite the aforementioned boom times, oil hit a low of $10 in 1998 alongside a rising dollar that was driving down prices of all commodities.

Analyzing the demand argument over longer stretches of time, the world economy expanded in the '80s and '90s as countries followed the lead of Great Britain and the U.S., and cut marginal tax rates. Despite the resumption of worldwide growth, U.S. consumers saw prices at the pump fall as the price of a barrel of oil plummeted in dollar terms. Currency watchers could have predicted this fall given the stated objective of Fed Chairman Paul Volcker and President Ronald Reagan to strengthen the dollar after the inflationary '70s.

Speaking of the '70s, the logical assumption about the oil price then would be that the slow growth and malaise that characterized the decade would have meant cheap gasoline. Oil of course rose in the '70s, and the conventional historical wisdom is that this resulted from the Arab oil embargo. The Cato Institute's Jerry Taylor has shown that those assumptions are indeed a myth, pointing out in the Los Angeles Times that, "It was no more possible for OPEC to keep its oil out of U.S. ports than it was for the U.S. to keep its grain out of Soviet silos several years later."

Oil did, however, become expensive in the U.S. in the '70s, rising 43% from 1975-79 despite a sluggish economy. There were probably commentators back then who pointed to the rise of Japan as a non-Arab explanation of this phenomenon, yet oil only rose 7% in Yen over the same period, while in Germany the "spike" in Deutschmarks was only 1%.

What this evidence hopefully shows is that as opposed to being an indicator of supply/demand imbalances, the price of oil, like the price of most commodities, is most useful as an indicator of dollar strength and weakness. For those who remain doubtful, they need only refer to the chart below, supplied by WTRG Economics.

That the chart starts in 1947 is particularly helpful in that from 1947 to 1971 the U.S. dollar's value was pegged to $35/ounce gold. During that period of currency stability, the price of oil was similarly stable despite five recessions and two notable expansions, including one that lasted 106 months from 1961 to 1969. Oil logically would have shown some volatility to reflect the booms and busts; that it did not is another indicator of the large role currency plays in its price.

Without getting into the merits (or lack thereof) of the Bretton Woods system, one has to at least conclude that dollar price stability greatly impacts oil price stability. Since oil is priced in dollars, it shouldn't surprise anyone that so long as the Fed allows the dollar to jump around in value, volatile oil prices will be the rule as opposed to the exception.

The other question that bears asking is to extent that supply and demand affect the price of oil, how much of this phenomenon is caused by dollar uncertainty and the resulting inability of oil producers to drill with long-term demand projections in mind? Did $10 oil in the late '90s herald the subsequent rise in oil prices that predates the dollar's more recent fall?

Currency volatility, as opposed to nations striving for U.S. standards of living, is clearly the elephant in the room when it comes to high oil prices. Here's hoping the aforementioned gets its due the next time China is used to explain away or hide Federal Reserve inability to maintain a stable dollar.

John Tamny lives in Washington, DC and can be reached at


TCS Daily Archives