Bread and Barter

One of the great intellectual failures of the late twentieth century was monetarism. This was the idea that, if you merely controlled the amount of money in an economy, you could control inflation; similarly, high inflation followed high rates of money supply growth. However, in the past decade we have seen money supply growth undergo an enormous burst and yet inflation has never broken 3-4% in most economies, which kind of negates the whole theory. Rather belatedly, even the author of monetarism, Milton Friedman, admitted towards the end of his life that "maybe I wouldn't have pushed it so hard". Clearly economics, which is merely the sum of shifting human behaviour, turns out to be much more complex than counting coins.

But what the low inflation/high money growth has left us with is highly indebted consumers who are disproportionately sensitive to small interest rate movements. Central banks simply cannot increase interest rates quickly enough, otherwise they could send their main customers into bankruptcy and the events of last July could merely resemble the curtain raiser to the main act. The likes of the US Federal Reserve, Bank of England and European Central Bank have, in a sense, gradually made themselves redundant. By putting themselves in an increasingly ineffective position (pretty much as the Bank of Japan has done over time), their actions have become increasingly constrained. Failing to "deliver" purposefully-designed recessions in order to bring the electorate back into line, the latter central banks have over indulged consumers to the point that they now lie bloated on the Couch of Economics, chomping the Potato Chips of Debt whilst watching the Television of Life. It's not a very appealing image, and that's why we've used it.

Rather than tackling money supply, there has been just as effective argument an for focussing on the thing that most western societies have been steeped in for the past 150 years to dictate interest rate policy: the price of hydrocarbons and oil. Oil and energy percolate through our every economic action: buying food, switching on a light, commuting, going on holiday, powering computers and manufacturing just about everything; even the seeds for those vegetables you are now so diligently growing in your back garden were transported using a truck. So, if you manage the economy with one eye on the oil price, you really are hitting at a commodity that is fundamental to economic activity at the deepest universal level. There is some evidence to show that, in the past, there has been a useful correlation between interest rates and the oil price (see first illustration with respect to the US) which looks like someone has been taking some notice. In fact, until 2001, the correlation was about +0.4, which isn't bad. If you want to put that into context, the doubling of the oil price in the past year, and the estimate that most people spend about 10% of their income on energy, would translate into an equivalent of a 4% rise in interest rates.

After that point things started to go wrong (see second illustration). Since 2001, the correlation has fallen but more importantly, in 2003, it turned negative; the oil price has soared but interest rates have fallen. If you had been managing interest rate policy via the oil price, interest rates would have gone up as well which might not have been such a bad thing if you think about it. All of the excessive borrowing that has led to the so-called ''Credit Crunch'' may have been averted by an increase in interest rates. However, precisely the opposite happened, and now we are in a situation where we are saddled with an insurmountable amount of debt which won't budge in value (mainly because lots of people now have interest-only mortgages) and most of our income is going towards paying the interest costs. The reality is that, for many people, there is little room for manoeuvre in their budgets. So the big swing factor now, in our lives and disposable income, is the basic cost of energy we consume. In effect, the New Monetary Policy is not interest rates, it's the oil price.

This should make for uncomfortable reading because most of ''our'' energy is concentrated in the hands of sovereign nations like Russia, Norway and the Middle East. Whether or not you believe that peak oil production has occurred, commodities (and those who hold them) now have the whip hand over the indebted West just at the time at which we need it the least. So as the oil price chugs towards the $135-a-barrel mark, you get the feeling that the market (and whoever is controlling it) is testing exactly where the tipping point for our economy is. When will you think twice about that trip to the shops or mall in your car, when it costs £150, £200 or £300 to fill your petrol tank? When you start talking in those terms, money starts to lose its meaning, a period when those countries with hard and valuable commodities will circumvent the system of (fiat) money and paper securities we have created, and rely more on the process of barter by which goods are exchanged between producers under legally binding long-term contracts. Wheat for oil anybody?

There are limits to what you can achieve in a page or so, but the conclusion we come to is that during this phase in which economies are being tested by the energy markets (the New Monetarism), the logical response by the interest-rate markets should be to go through a process of reducing the cost of borrowing and debt servicing in order to keep the system in some kind of equilibrium. Otherwise they could fall over. Admittedly, when we all know that inflation erodes the value of fixed-rate investments this seems somewhat incongruous, but actually what we need is a period of negative real interest rates in our highly indebted and energy-dependant societies. Whether we get it or not is another matter, but if we don't, it could spell trouble.