The Austrian School provides a new angle on the development of the oil price. We already discussed the oil price development from the perspective of the Austrian School of Economics in our Oil Reports 2010 and 2011. The recent economic events have caused a renewed interest in the ideas of the Austrian School. The purpose of our Oil Report is to provide the reader with a better basis for decision-making on the back of the facts and analyses presented in this write-up.
Focus on price and market
If we had the chance to meet Ludwig von Mises in a Vienna café in order to discuss the current oil market and the development of the oil price, he would, having ranted at length about current political events, draw our attention to two basic aspects: 1) price and 2) market. Von Mises would explain to us that the price in its original, pure form is nothing but the expression of a barter ratio of goods or services. In this original form prices send correct signals about the actual availability of real goods to the market participants. These participants can take correct production decisions on the basis of the availability of real goods. In a free market society money itself would be a good, which would ensure that all prices are always the manifestation of barter ratios.
Let’s assume for example that in a free village economy about 10,000 ounces of silver are in circulation, and that the market participants use this silver as currency (N.B. most marketable good) in their transactions. At the moment the following exchange rates for barter transactions have established for 1kg of potatoes and 1kg of tomatoes:
Barter table – starting point
1 kg of potatoes ½ ounce of silver
1 kg of tomatoes 1 ounce of silver
Let’s assume the village is gradually discovering the blessings of crop rotation in agriculture, as a result of which the crop of potatoes and tomatoes doubles after five years at a constant input of labour and land. The exchange ratios of silver, potatoes, and tomatoes would settle according to the following table:
Barter table – after the discovery of crop rotation
1 kg of potatoes ¼ ounce of silver
1 kg of tomatoes ½ ounce of silver
This development would correctly signal an excess of potatoes and tomatoes to the market participants. The barter/exchange ratios of all food would gradually decline, making other activities (e.g. livestock breeding) more attractive. In the opposite case, where the crop decreases (e.g. because of erosion) the barter ratios would shift in favour of potatoes and tomatoes (and other food).
Barter table – after soil erosion
1 kg of potatoes 1 ounce of silver
1 kg of tomatoes 2 ounces of silver
This increased barter rate of tomatoes and potatoes would induce the villagers to invest more resources (labour, brain power) in agriculture in order to keep famine at bay. It is important to realise that the natural order of money sends the right signals to the villagers with regard to the stock of real goods in the village economy, thus enabling them to live and survive in harmony with the available resources.
Fiat money – “the magic wand”
A natural monetary system, where money itself is a good, is a closed system, within which all market participants are forced to take either/or decisions all the time. In order to obtain money (i.e. the most marketable good) every market participant has to enter a good into a barter transaction (or of course steal – but that, too, keeps the money supply constant). The cunning aspect of this system is the fact that in every transaction every market participant has to subject himself to the actual stock of real goods.
However, as soon as the price is expressed in terms of fiat money, the natural way of establishing the price loses its basis. Fiat money is by definition created from “nothing” and thus breaks the closed circle of a natural monetary system. Those institutions and persons with the biggest influence on the fiat monetary system can thus shake off the shackles of the natural, limiting money and are not confined to either/or decisions anymore. Rather, they can fulfil all their wishes at the same time – of course at the other members of society’s expense, as the material limitations have not changed. The consumption preferences of those controlling the fiat money therefore also have the biggest influence on the price system in the economy. This influence comes with grave consequences: due to the signalling effect that the prices have for the market participants (tomorrow’s production decisions are based on today’s prices) it is possible to influence the entire production and consumption structure of an economy via the introduction and control of fiat money.
In a fiat monetary system it is therefore crucial to consider not only the development of the two components’ supply and demand, but also that of the fiat money supply. If for example the money supply in circulation rises more quickly than the oil supply, the oil price – expressed in fiat money – will probably rise although the demand situation has not changed. Price fluctuations are then not only caused by changing supply and consumer preferences anymore, but also by changes in the money supply. This makes everything much more complicated. Ludwig von Mises would therefore advise us to study the money supply statistics in detail and also to think about what institutions exert a dominant influence on the fiat monetary system and closely monitor their interests.
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The second essential point is the structure and the system of the market where supply and demand meet and prices are established as the outcome of the process. In order for the price to actually reflect the supply and demand situation, the market has to be transparent and the process of price discovery has to be retraceable for all participants. Historically speaking, prices used to be very regional, and prices used to be established on the basis of the very regional physical supply and demand situation. The technological progress in information technology and transportation has furthered the global integration of markets.
In addition, so-called forward exchanges have developed over the centuries. This development has led to a situation where there are not only daily prices for numerous commodities, but also prices for delivery at some future date. Basically the question emerges how daily prices (spot prices) and future (forward) prices influence each other. For example if the forward price is clearly above the spot price (in a way where inventory and financing costs are more than covered) commodity producers will not sell on the spot market, but will prefer to sell forward and thus postpone delivery. This reduces the physical supply on the spot market; at constant demand, the spot price will rise and follow the forward price. Given that the forward market is a “paper market”, where contracts are traded on margin, it is possible to gain substantial control over forward prices, with very low amounts of money. Ludwig von Mises would therefore strongly advise to take this fact into consideration in forming one’s price expectations, especially in the short run.
By. Gerald Walek, CFA
