Austrian School opens up new angle on oil price development. In our Oil Report 2010 we analysed the development of the oil price for the investors for the first time from the point of view of the Austrian School of Economics. Representatives of the Austrian School (especially Ludwig von Mises) saw that a centrally managed system of fiat money made the natural order of the free market topple over. This, in the opinion of the Austrian School, destabilising influence of a centrally managed fiat monetary system is reflected by booms and overheating as well as recessions and economic crises in the real economy.
Money/credit cycle – two stages. When considering the future oil price development we believe it is therefore helpful for the investors to be aware of the impact of centrally controlled monetary measures on the real economy. This money and credit cycle usually comes in two stages. In the first stage (loosening cycle), the banking system gradually accelerates lending to private households, companies, and the public sector as a result of the centrally controlled expansive monetary policy (key interest rate cuts, reductions in minimum reserve requirements for the banking system, expansion of the central bank credit). This is the period of time that is usually associated with a good economic development. This is also where bad investments occur, which in the absence of real resources cannot be fully employed.
Two essential factors lead to rising prices in this phase. On the one hand the rising price level merely reflects the fact that given the expansive monetary policy the economic players have more currency units at their disposal. On the other hand the pressure on the “maintenance fund” (i.e. capital goods and the part of the population that is fit for work) increases because of the rising investment and consumption demand. In order to fight these unpleasant side effects of the upswing, the centrally managed monetary policy enters stage 2 – the tightening cycle (increase in key lending rates and minimum reserve requirements, reduction or stabilisation of central bank credit). As a consequence lending by banks to companies, households, and the public sector declines. With a certain time lag, more and more economic participants with outstanding debt come under pressure due to the declining lending volume and as a result of the lack of refinancing options. The bad decisions that were taken in the first stage are now gradually emerging, and economic resources (capital goods and labour force) have to be re-allocated. We know this stage as recession.
Disparate development of the global economy. In the wake of the collapse of the US investment bank Lehman Brothers in October 2008 the most important central banks of the world embarked on an expansive monetary policy (interest rate cuts, reductions in minimum reserve requirements, expansion of central bank credit). From a regional perspective, the various economies have shown a mix of reactions to this stimulus. Whereas the most important emerging markets (China and South East Asia as well as South America) reacted promptly in 2009, the USA and Western Europe showed a rather subdued reaction.
The most important emerging markets have already progressed to stage 2 (tightening cycle) of the monetary cycle. The most important emerging markets such as China, India, or Brazil have been affected by the rapidly rising price level since the second half of 2010. This is simply a symptom of the massive lending we had seen 12 to 18 months before. It therefore comes as no surprise that China and also Brazil have taken more defensive monetary steps since the first half of 2010 (interest rate hikes, increase in the minimum reserve requirements for banks, redemption of central bank credit). The following chart illustrates this development. Whereas in China credit growth (red line) already picked up considerable momentum in 2009, the Eurozone (grey line) and the USA (blue line) only started to record a rising trend in the second half of 2010 (i.e. with a time lag of 1.5 years).
Debt in the USA, Eurozone, and China Mar-04 – Sep-1
Sources: ECB, US Fed, PBoC
Eurozone and USA still in stage 1 (loosening cycle) of the monetary cycle. The graph also shows that lending in the Eurozone and in the USA picked up a bit only in the second half of 2010 again, which means that the most important developed markets are still in stage 1 of the monetary cycle. This is also substantiated by the fact that both the ECB and the US Federal Reserve still pursue an expansive monetary policy (no interest rate hikes so far, central bank credit keeps getting expanded – “QE2”).
Improved credit dynamics in Europe and the USA buys the emerging markets time. We believe that the economic development of the emerging markets is the main driver of commodity prices and crude oil. Since these countries are already in stage 2 of the monetary cycle, investors should be cautious with commodities. But as long as there are no problems in the property or financial sector (especially in China), we expect the positive trend of the commodity prices and thus also for crude oil to last. In this context it is also worth noting that the continued acceleration of lending in the USA and the Eurozone lengthens the time axis of the cycle for the emerging markets. This means that the bad investments that were probably made in 2009 and 2010 on the back of the massive credit growth in the emerging markets will remain undisclosed for a while.
On the basis of the theories of the Austrian School we can still see a moderate upward potential for the commodity prices in the short term (six to twelve months). But for the medium term (one to three years) our analysis based on the Austrian School leads us to conclude that commodity prices will incur a massive setback, much like in 2008 and 2009. This is mainly due to the fact that the monetary measures that were taken in 2008 and 2009 are very similar to those taken in 2001 and 2002 after the dot.com crash and that were ultimately the seed of the financial crisis in 2007 and 2008.
By. Ronald Stoeferle of Erste Group
Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.