A Strong Dollar Will Reduce Oil Prices

In less than one month, oil prices have fallen nearly 22%. That drop happened during a period when our leaders in Washington accomplished exactly nothing of importance that could account for the fall. Sure, President Bush lifted the moratorium on offshore drilling, but that action will have no effect unless Congress follows suit.

Most likely the fall had nothing to do with the impending expiration of the drilling moratorium, but rather is a reaction to the recent strengthening of the US dollar. There has been a lot of discussion over whether the dollar has risen because oil has fallen or if the reverse is true, but based on history, it seems obvious to me that it is the dollar driving oil prices and not the other way around.

Although there are significant differences between the current economic environment and the 1970s, there are also significant similarities. As then, the current high price of oil has little to do with the supply and demand for that commodity. The problem then and the problem now is the supply and demand for US dollars. Soon after Reagan’s inauguration in 1980, the dollar started a rise that continued until the Plaza Accord of 1985. The trade weighted dollar rose roughly 50% and the price of oil fell by a similar amount. That rise was no accident. It happened because of the tight monetary policy of Paul Volcker and the growth promoting tax policies of Ronald Reagan. After the Plaza Accord and the coordinated effort to devalue the dollar, oil prices responded as one would expect, doubling by 1990.

Politicians are currently locked in a battle over energy policy which ignores the real cause of the problem and therefore offers no solution. Those on the left alternately argue that we haven't had any energy policy, or that current policy is a result of the Bush administration rewarding its oil industry benefactors. Politicians on the right argue that a lack of domestic production, due to environmental policy, is to blame. Both claim that enacting an energy policy is a matter of national security.

These arguments are all incorrect and largely irrelevant.

Regardless of politicians’ high regard for their own abilities, the high price of oil has little to do with any energy policy that was enacted, or not enacted, by a previous Congress. The ban on offshore drilling and in the ANWR region merely reduced domestic production while having little effect on the amount of oil being placed on the market. If we had increased production here over the last 30 years, it is logical to assume that producers outside the US would have decreased production to maintain prices at acceptable levels.

The real culprit in the rise in oil prices has been a monetary policy more concerned with growth than inflation. The successive bubbles in stocks, real estate and now commodities are prima facie evidence that monetary policy has been driving asset prices. Yes, there has been an increase in demand from China and other emerging markets, but the oil industry has met that demand, over time, with capacity to spare. New discoveries are adding to known reserves regularly. New technology is making previously unrecoverable oil, well, recoverable. It is not a lack of supply that is driving the price of oil.

The distortions caused by bad monetary policy are now creating a sense of urgency on the part of lawmakers. For now Congress is in recess, something for which we can all be thankful. But they will eventually return. I don't expect them to accomplish anything in the lame duck session since expecting Congress to actually pass meaningful legislation in an election year is like expecting Michael Jackson to become normal. But with a new administration, the danger increases that they will pass legislation that will not only fail to reduce oil prices but also damage the economy as a whole.

There are obviously other factors which influence the price of oil and other commodities, but it is also obvious that the value of the US dollar is the major factor. A reduction in demand due to high prices has contributed to the recent decline in the price of oil as has in increase in supply from Saudi Arabia and the potential for increased supply from more domestic drilling.

Furthermore, the recent strength of the dollar would seem to be more of a tallest midget phenomenon rather than a result of any overt policy change by the US. The decoupling thesis, where the rest of the world continues to grow even as the US slows, has been proven as wrong as every other “it’s different this time” thesis.

Ultimately, the value of the dollar is determined by the supply of and demand for US dollars. The current credit contraction is reducing the supply of dollars despite the best efforts of the Federal Reserve. In a world of fractional reserve banking, the Fed’s control over the supply of dollars via interest rate manipulations is limited at best. Any increase in demand for the dollar is not a result of good policy here but rather worse policy abroad. These factors have pushed the dollar higher for now, but if it is to be sustained, good policies must be enacted to support the demand for dollars.

Congress should enact pro-growth policies that act to increase the demand for dollars. Increasing capital gains taxes and marginal tax rates are not policies that will achieve that goal. A windfall profits tax on oil companies is not a policy that will achieve that goal. A cap and trade system to limit carbon emissions, endorsed by both candidates for President, is not a policy that will achieve that goal. Pro-growth policies would favor lower marginal tax rates, lower capital gains taxes (or better, none), less regulation, lower corporate tax rates (or better, none) and deficit reduction through lower government spending.

While Congress can and should enact pro-growth tax policies, a much more important task is to reform the Federal Reserve. The fist step should be to clarify the Fed’s mandate. Now, the Fed is tasked with maintaining growth and minimizing inflation. The only way for the Fed to truly accomplish the first goal is to concentrate exclusively on the second. It should also be made clear that inflation is defined as an expansion of the money supply and not a rise in price of an arbitrary basket of goods. The best way to accomplish currency and price stability is to adopt a gold standard but in the absence of political will for such a policy, a single mandate is a good first step.

We cannot drill our way to lower oil prices nor can we tax our way to prosperity. Growth cannot be created through policies that encourage consumption over savings and investment. The Fed needs to act to reduce and then stabilize the price of gold (increase the value of and then stabilize the dollar). Congress needs to act to create an environment that promotes growth through private investment. That’s what Ronald Reagan and Paul Volcker did in the early 80s. It worked then; it’ll work now.