The Downsizing of the Dollar in Oil Prices

One important fact about oil consumption is usually overlooked — the oil price in dollars has risen much more than the price of oil in euros or even in yen.

This is because the dollar has lost so much value relative to the euro and the yen. Since George W. Bush took office at the beginning of 2001, the value of the dollar has fallen from 1.07 to 0.77 euros per dollar.

That fall has softened the rise in the price of oil for Europeans. In dollars, the price of petroleum has more than doubled. In euros, the price has risen by 50%.

The falling dollar has made the petroleum price crunch much more severe for Americans than for people in other rich countries.

The bad news to come is that this might get a lot worse — fast. The price of oil and the value of the dollar have taken quite a ride since Mr. Bush took office.

Data compiled by the author. Copyright © 2005 The Globalist.

Ignoring the high frequency of ups and downs and just looking at annual averages, the story is pretty simple: The price of oil has gone up, up, up — and the value of the dollar has gone down, down, down.

These are not isolated trends. While they are not joined at the hip — various influences on the supply and demand for both oil and dollars enter the story — they have one powerful common source.

The value of the dollar against both oil and other currencies is falling because the United States is issuing too many dollar-denominated IOUs.

The big change since the late 1990s is in the government sector, where large budget surpluses have been converted into huge annual deficits.

Nobody, from oil exporters and private individuals to businesses and foreign central banks is happy to accumulate the flood of Treasury securities that the United States is selling to finance these deficits.

What is more, the U.S. Treasury depends on the rest of the world to buy new U.S. debt issues because U.S. buyers don’t want them. Instead, American consumers and the federal government are engaged in a frenzy of consumption, going more and more into debt, leaving the rest of the world to pick up the tab.

Apart from the Social Security trust funds and the Federal Reserve, other wealth holders in the United States — that is, private institutions and businesses — own fewer Treasury securities today than they did when President Bush took office, even though the total national debt held outside the U.S. government has grown by more than $1 trillion since early 2001.

Everybody expects U.S. interest rates to rise as the government issues more and more debt. The pressure for the dollar to fall — especially against Asian currencies — is growing stronger.

Nobody wants to accumulate too much of this depreciating paper. “Nobody” includes the oil exporters.

In fact, were it not for the central banks of China and Japan, which are trying to preserve the competitive edge of their exports, the dollar would have fallen much further already.

It is inevitable that the dollar will fall, especially against Asian currencies. When this happens, the rising prices of raw materials and basic industrial inputs, already producing inflationary pressure in the United States, will be joined by rising prices of manufactured imports. We can expect a sharp rise in the rate of U.S. inflation.

The prospect of rising inflation and interest rates has helped fuel the demand for real estate, with buyers eager to lock in low mortgage rates, even in the overheated property market of California and the east coast of the United States.

Prices of these assets, like prices of financial assets, are at levels that cannot persist.

What does the future hold? Will the dollar continue to sink gently while the price of oil rises? Will interest rates adjust gradually and property values level off?

That is the optimistic scenario. Steady price movements are what one hopes for when markets become jittery. The alternative is a rush to the exits, a crisis — with a lot of blood spilled in the struggle not to be left behind.

The Bush Administration is fiddling with tax rates, trying to lower them further and cement earlier “temporary” tax cuts in place.

At the same time, it shows no sign of getting serious about cutting spending or raising some taxes. It’s time to take notice, fellows. You might be headed for a fall.