Historically, low oil prices have been perceived by many as an overriding positive for the economy.
This has especially been the case in the United States where most households rely on car travel as a primary means of transport. Low oil prices allow households to spend more on economic activities other than gasoline and other oil-related expenses. Historically, every time the oil price soared — such as the 1973 oil crisis, the 1991 Gulf War, and in 2008 when oil reached a historical high of $147 a barrel — public opinion always regarded these events as a serious threat to the economy.
It was often understood that falling oil prices have many benefits both for the economy and for those subject to monetary policy. For example, price inflation is reduced when oil prices fall, which lowers pressure on the central bank to raise interest rates. And, all things being equal, the economy benefits from the price stability and lessened intervention on the part of the central bank.
Oil Prices and the “New Normal”
However, by the third quarter of last year, falling oil prices were not being hailed as good fortune. Instead, commentators claimed the economy would suffer as a result. In fact, ever since the global financial crisis of 2008 occurred, this counter-intuitive analysis is promoted as a part of the “New Normal” which is widely believed to be kick-started by the Fed’s unprecedented easy-money policies.
Nevertheless, the argument in favor of high oil prices is logically not difficult to grasp: the longer oil prices stay above $100, the more investment would pour into new oil fields and also new energy alternatives to oil and shale gas. The result is an increase in employment in the oil industry.
The costs of such projects were only justified in the case of high oil prices. So, when oil prices go into decline, many companies — or at least many extraction operations — will consequently lose competitiveness and be forced to shut down. Layoffs will follow and the ripple effect brings more unemployment and an unwanted increase in bad debts.
Will Central Banks Hit the Panic Button?
At this point, Keynesians step in and argue central banks have an important role in “fixing” the problem. That is, they will argue that the central banks should offset the subsequent risk of deflation by increasing the money supply.
First of all, note there is a double standard at work here. When oil prices rise, the central bankers claim there is too much volatility in oil prices and so the central bank will exclude energy prices from core inflation and postpone an interest rate hike. But when oil prices fall, the central bank no longer focuses on core inflation, but looks to a broader deflationary view that includes energy prices. Then, the response is to cut interest rates further.
Regardless of whether the oil price is high or low, central banks can come up with a rationale to adopt a loose monetary policy in order to fit the agenda that suits them.
It is important to clarify that falling oil prices that follow massive investment in extraction (causing layoffs, unemployment, and increases in bad debts) may harm a set of individuals or certain industries, but for the long-term development of the overall economy, it is a good thing. We must understand that after the financial crisis of 2008, a variety of resources — including oil prices — experienced a V-shaped rebound because both the US and China, the biggest two economies in the world, undertook a substantial increase in government spending and embarked on unprecedented credit-creation programs.
These government “stimulus” programs inevitably caused overinvestment (i.e., malinvestment) in many industries, and, in the most recent cycle, the oil industry is one such industry.
The Role of China
However, in 2010, the Chinese government became concerned about malinvestments and inflation and the People’s Bank of China began significantly tightening the money supply (although they again turned to easy money last November). This led to a slowdown in China’s economic growth, and falling demand led to a drop in the prices of commodities — first copper and iron, and subsequently energy.
Moreover, the increase in the oil supply (due to the shale gas revolution), and reduced demand, combined for a double attack, until finally a substantial decline in oil prices appeared this year.
A Necessary Correction
The oil industry and related industries are facing the inevitable: companies which miscalculated and predicted ongoing price growth will go bankrupt, and industry resources will be acquired by investors with more insight. The short-term pain the oil industry is currently facing is necessary, and governments and central banks must not stop this natural process through misguided stimulus in an effort to prevent oil company layoffs. Such efforts are likely to only benefit the giant oil companies, as we witnessed in the wake of the 2008 crisis where the biggest banks were the biggest winners.
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