Never Reason from a Price Change

Many of my students think that we can expect consumers to buy less gasoline when the price is high, and vice versa.  In fact, the opposite has more often been true in recent decades, as oil demand shocks have become more important that oil supply shocks.  More oil was being consumed when prices hit $147 (due to high demand) than a year later when prices had fallen in half (due to lower demand.)

Paul Krugman’s much too smart to make that mistake, but he comes close in this post:

Tim Duy has an interesting point about the impact of the euro crisis on the United States: in the short run, it may help, not hurt, our prospects for recovery.

Many of us have noticed that the US exports only a bit more than 1 percent of GDP to the euro zone, limiting the direct negative impact. Meanwhile, as Duy points out, the immediate impact of the euro crisis has been (a) a fall in oil prices (b) a fall in long-term interest rates. Both of these are actually positive for the US.

Technically this is correct, as Krugman and Duy are only looking at the partial effect of lower prices on imported oil.  The euro crisis has clearly lowered expected NGDP growth in the US and indeed throughout the world.  The lower expected NGDP growth will tend to reduce long term interest rates and commodity prices.  And it is true that for any given level of AD, lower oil prices are expansionary (as AS shifts right.)   But at a deeper level it is very misleading.

There is a reason why both long term rates and commodity prices are strongly correlated with severe AD shocks; both reflect the fact that output of manufactured goods and investment demand are highly cyclical.  When NGDP fell sharply below trend in late 2008 and early 2009, both (real) commodity prices and nominal long term rates fell sharply.  Those were not hopeful signs; rather they were indicators that AD was coming in far below target.

So yes, it is technically true that, ceteris paribus, lower oil prices and long terms rates can be helpful.  But if you wake up in the morning and pick the paper, and see this headline:

Oil Prices Plunge, Treasury Bond Prices Soar.

You should be afraid, very afraid.

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

The markets are telling us that the euro crisis is hurting recovery in the US, not helping.  It’s easy to laugh off the highly erratic markets.  But before doing so perhaps we should recall that the markets were also tell us that money was far too tight in September 2008.  The Fed ignored those warnings.  I have a hunch that right now they’d like to redo the September 16, 2008 meeting.

Krugman’s post was in support of an earlier post by Tim Duy.  Duy makes a good point when he notes that the Asian crisis of 1997-98 did not slow growth in America.  And I’d have to admit that the markets did not cover themselves in glory during that episode.  But I still think the Keynesian approach to AD misses something important.  Lower long term rates look like an exogenous shock that is expansionary, whereas I believe they mostly reflect lower growth expectations worldwide (confirmed by falling equity prices.)  It’s true that US exports to Europe are modest, but if the strong dollar is symptomatic of unintentional tightening of monetary policy, despite low rates, then it may not be good news at all.  An increased demand for dollars will look almost invisible from the perspective of the Keynesian C+I+G+NX approach to AD.  (I suppose it would be attributed to less “animal spirits.”)  But as we saw in late 1937, a scramble for liquidity can be highly deflationary even if the financial system is in good shape.  We are certainly not facing a crisis, but this is something the Fed needs to watch carefully.  The last time the dollar soared against the euro was July-November 2008.  And how’d that work out?

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