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Dispellng Economic Myths


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This myth pops up from time to time and I won't reference any particular sources since many are political (you can google them if you want -- I think the movie Syriana even referenced it with a straight face). However, the ramifications are not necessarily political so I'll start the discussion here and hopefully it won't get out of hand.

There are various strands and offshoots of this myth, some incredibly nutty (but probably more appropriate for the politics forum), but it usually springs from at least one, and often both, of these propositions:

1) Because of the US dollar's sharp depreciation in the past few years, pricing oil in USD is bad for oil exporters.

2) If oil were suddenly denominated in another currency (the Euro is most frequently mentioned) that would cause a complete collapse of the dollar.

Let's tackle these one at a time.

1) Currencies are just measuring units. If you halve the size of the measuring units, what you are measuring doesn't double in size. To tie it to currencies and oil -- if the dollar's nominal exchange rate depreciates by 20%, then the dollar price of oil will increase instantaneously by about 20%. This will be true if oil is priced in euros, dollars or coconuts. If oil is priced in dollars, you are selling it, and you want the income in euros, you can easily and quickly carry out a foreign exchange operation to achieve your goal. What this means for oil-producing countries is that it doesn't matter in which currency oil is priced. Regardless of whether oil is priced in euros, dollars or coconuts, a 20% depreciation of the dollar against the euro (or coconut) will cause the price of oil to go up by 20% in dollars and remain unchanged in euros (or coconut).

2) The value of currencies is determined, like most things, by supply and demand. So when demand for a currency falls off relative to another currency, that exchange rate will depreciate. So, to the degree that it is necessary to own a currency in order to buy oil contracts denominated in terms of it (this degree may equal close to zero), repricing oil in a different currency will reduce demand for dollars. However, as a percentage of total dollar transactions taking place daily, I am guessing that oil is a relatively small fraction. So IF repricing oil in terms of euros, Ukrainian Hryvnia or coconuts reduces demand for dollars (a big IF), it will not reduce demand for dollars by very much. It is possible that this kind of move would trigger a dollar panic (what game theorists call a sunspot effect), but in and of itself it won't make much of a difference.

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This is totally unrelated to the question of whether oil-producing countries should peg their currencies to the dollar. The answer is "probably not", unless they want to experience depreciation of their currency and inflation.

Guy

Guy

Edited by Guy
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You save quite large transaction costs if you don't need to convert your money to dollars in order to buy oil.

There are some numbers around on how much the oil money is and what the rest of the dollar transactions are. Can't find them offhand but I had an impression that it was big enough to be a "sunspot" issue, which could start a slide.

MG

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...

1) Currencies are just measuring units. If you halve the size of the measuring units, what you are measuring doesn't double in size. To tie it to currencies and oil -- if the dollar's nominal exchange rate depreciates by 20%, then the dollar price of oil will increase instantaneously by about 20%. This will be true if oil is priced in euros, dollars or coconuts. If oil is priced in dollars, you are selling it, and you want the income in euros, you can easily and quickly carry out a foreign exchange operation to achieve your goal. What this means for oil-producing countries is that it doesn't matter in which currency oil is priced. Regardless of whether oil is priced in euros, dollars or coconuts, a 20% depreciation of the dollar against the euro (or coconut) will cause the price of oil to go up by 20% in dollars and remain unchanged in euros (or coconut).

This is totally unrelated to the question of whether oil-producing countries should peg their currencies to the dollar. The answer is "probably not", unless they want to experience depreciation of their currency and inflation.

Guy

Guy

This begs the question. Why do they price oil in dollars? Convenience? To simplify the buying and selling?

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It is also worth noting that nearly all international commodities markets are dollar-denominated. Oil makes the headlines, but precious metals, grains, etc all trade in dollars. Some part of the gains seen in international commodities markets over the past couple years is attributable to the declining value of the dollar, which speaks to Guy's first point.

The second point I think is a little more slippery, and I *think* Guy would agree with me on that. There would doubtlessly be some impact, but it is not likely to be catastrophic. It seems to me the most likely consequence would be some degree of upward pressure on interest rates. I happen to disagree with Guy on the impact of dropping the dollar standard on demand for dollars; I think there would be a real effect (just look at how many dollars foreign governments keep on their balance sheets - I think that at least to some extent this represents a hedge against the effect of currency fluctuations on commodities markets).

Finally, to the extent that everyone realizes there is a non-zero probability of OPEC dropping the dollar standard, this has already been priced into the dollar.

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1) Currencies are just measuring units. If you halve the size of the measuring units, what you are measuring doesn't double in size. To tie it to currencies and oil -- if the dollar's nominal exchange rate depreciates by 20%, then the dollar price of oil will increase instantaneously by about 20%. This will be true if oil is priced in euros, dollars or coconuts. If oil is priced in dollars, you are selling it, and you want the income in euros, you can easily and quickly carry out a foreign exchange operation to achieve your goal. What this means for oil-producing countries is that it doesn't matter in which currency oil is priced. Regardless of whether oil is priced in euros, dollars or coconuts, a 20% depreciation of the dollar against the euro (or coconut) will cause the price of oil to go up by 20% in dollars and remain unchanged in euros (or coconut).

The assertion that there is a perfect negative correlation between the exchange value of the dollar and the price of oil is false . The supply and demand functions of oil and the dollar have no such identity . In the last six years the dollar has depreciated 65% against the euro , while oil prices are up nearly 300% in dollar terms . This is the real reason that pricing oil in dollars has not been bad for oil-exporters thus far. What happens however when their growth in oil receipts normalizes , while the dollar continues its long-term depreciation against major currencies ?

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The assertion that there is a perfect negative correlation between the exchange value of the dollar and the price of oil is false .

That is obvious, but it isn't what Guy asserted. What he asserted is if the value of the dollar drops by X%, then this will have an X% upward impact on the dollar value of oil prices. Other forces could have additional upward or downward impact on prices.

In response to your question, I think you are asking what would happen if oil revenues as expressed in dollars flattened while the dollar continued to depreciate relative to other currencies, say the Euro. All this would indicate is that the value of oil was declining in "real terms" (I'm slightly abusing the language but you know what I mean). If priced in Euros, it would be observed to be declining in "nominal terms" as well. Any other possibility is ruled out by arbitrage.

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You save quite large transaction costs if you don't need to convert your money to dollars in order to buy oil.

I am not sure this is true. I would guess that most who trade oil contracts use such large volumes that the transaction costs are tiny in relative terms.

There are some numbers around on how much the oil money is and what the rest of the dollar transactions are. Can't find them offhand but I had an impression that it was big enough to be a "sunspot" issue, which could start a slide.

MG

FWIW, I should probably explain the sunspot term for the non-economists (sorry, MG, you're one of the "economists" whether you like it or not) -- what I mean is an event which triggers a change in agents' behavior (and consequently the equilibrium) even though it doesn't directly affect their payoffs. For example, one morning there is a sunspot, everybody who trades dollars sees it and decides they no longer want to hold dollars. Because nobody wants to hold dollars, the value of the dollar collapses. This is despite the fact that the sunspot itself did nothing to alter the value of the dollar.

Guy

Edited by Guy
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Because historically the dollar has been one of the least volatile and most plentiful currencies.

Not sure about that. The Japanese Yen, Deutsche Mark (sp) and Swiss Franc have generally been more stable. The problem is that those nations have kept interest rates low.

The dollar was primarily used because it was the main source of foreign reserves for nations. Why? Well is was somewhat stable, but more importantly, it offered a nice mix of relative stability plus nice return on the treasury notes.

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You save quite large transaction costs if you don't need to convert your money to dollars in order to buy oil.

I am not sure this is true. I would guess that most who trade oil contracts use such large volumes that the transaction costs are tiny in relative terms.

You know, I would have thought that too, but then Buffett said last year that he was no longer trading in foreign currencies because the costs had grown too large, and was instead focusing on acquiring foreign equities (using USD). I have nearly no knowledge of the associated costs, but this did surprise me. My knowledge on this issue is limited to the point where I don't know how it would affect the entities typically engaged in oil trading.

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Because historically the dollar has been one of the least volatile and most plentiful currencies.

Not sure about that. The Japanese Yen, Deutsche Mark (sp) and Swiss Franc have generally been more stable. The problem is that those nations have kept interest rates low.

The dollar was primarily used because it was the main source of foreign reserves for nations. Why? Well is was somewhat stable, but more importantly, it offered a nice mix of relative stability plus nice return on the treasury notes.

OK, I should have phrased that more carefully. During the period in which the decisions were made which led to the dollar being the standard pricing unit for international commodities markets, the dollar had a history of being the least volatile currency in large supply.

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does not devaluation of the currency suggest that interest rates need be significantly increased to maintain current foreign investment levels in our economy?

low returns on devalued currencies just wont fly. the 11 percent citi is paying would seem to be about right.

Edited by alocispepraluger102
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The assertion that there is a perfect negative correlation between the exchange value of the dollar and the price of oil is false .

That is obvious, but it isn't what Guy asserted. What he asserted is if the value of the dollar drops by X%, then this will have an X% upward impact on the dollar value of oil prices. Other forces could have additional upward or downward impact on prices.

I stand by my criticism of Guy's original assertion ( and by extension , your reformulation ) .

Guy's statement contains two elements . First , he asserted the existence of a - 1.0 coefficient of correlation between the dollar-euro exchange rate and the price of oil - when the dollar weakens against the euro , the price of oil increases . Please note that my criticism of Guy's assertion does not rest ( as you supposed ) on a claim that it cannot explain all of the rise in the price of oil . Two , he asserted , that the slope of the regression line has a unity value - if the dollar depreciates by 20% against the euro , then the price of oil increases by 20% . Both these claims are false .

As to the first , normally in any given year the dollar depreciates ( at various rates ) against some currencies and appreciates ( at various rates ) against others , so one needs to specify which cross-rate is correlated with the price of oil . Guy used the dollar-euro cross , which as it happens does have an approximately - 0.7 coefficient of correlation with the price of oil , owing to the importance of the trade between the eurozone and the oil-exporters . Contrary to his assertion however , this means that there are contemporaneous periods where the price movements of both the dollar-in-euros and the price of oil are in the same direction . That said , now that the dollar is depreciating against all major currenices , looking at a trade-weighted average of dollar-exchange rates might reveal an even stronger negative correlation with the price of oil .

As to Guy's second claim , even if the correlation were - 1.0 ( the result of the desire of the oil-exporters to maintain their purchasing-power in the non-dollar world ) there is no reason to expect that an X% move in the dollar leads to an X% move in oil . There is a tendency here , not a mathematical necessity for equivalence . My reason for pointing out that the recent rise in the price of oil has far outstripped the depreciation of the dollar , was to remind everyone that the supply and demand fundamentals of oil are vastly more important determinants of the price of oil than the supply and demand of dollars . This is not to say that leveraged speculation has not also been a factor in oil's recent meteoric rise .

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Guy used the dollar-euro cross

I don't see that in his post at all. I took Guy to mean this: hold all currencies other than the dollar fixed wrt to each other. Now take X% off the value of the dollar. All else being equal, this will have an X% impact on oil prices as expressed in dollars. Your last paragraph seems to me to fit under the disclaimer "obviously other factors can exert upward or downward impacts on oil prices".

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Guy used the dollar-euro cross

I don't see that in his post at all. I took Guy to mean this: hold all currencies other than the dollar fixed wrt to each other. Now take X% off the value of the dollar. All else being equal, this will have an X% impact on oil prices as expressed in dollars. Your last paragraph seems to me to fit under the disclaimer "obviously other factors can exert upward or downward impacts on oil prices".

Invoking ceteris paribus is , as it usually is , explanatorily vacuous . I await Guy's clarification of his assertion .

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Because historically the dollar has been one of the least volatile and most plentiful currencies.

Not sure about that. The Japanese Yen, Deutsche Mark (sp) and Swiss Franc have generally been more stable. The problem is that those nations have kept interest rates low.

The dollar was primarily used because it was the main source of foreign reserves for nations. Why? Well is was somewhat stable, but more importantly, it offered a nice mix of relative stability plus nice return on the treasury notes.

OK, I should have phrased that more carefully. During the period in which the decisions were made which led to the dollar being the standard pricing unit for international commodities markets, the dollar had a history of being the least volatile currency in large supply.

I think this is also a relic of the post-WW2 Bretton Woods system which set up exchange rates fixed to the dollar. By the time the system was abandoned in the early 70s the dollar had effectively become the reserve currency even though exchange rates were no longer fixed.

However, things can change.

Guy

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does not devaluation of the currency suggest that interest rates need be significantly increased to maintain current foreign investment levels in our economy?

Well, by most estimates the US has been borrowing too much from the rest of the world in the past decade or two (a great deal for us!) and some decline in net borrowing from abroad, as long as it is not too sudden, would be a good thing.

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The assertion that there is a perfect negative correlation between the exchange value of the dollar and the price of oil is false .

That is obvious, but it isn't what Guy asserted. What he asserted is if the value of the dollar drops by X%, then this will have an X% upward impact on the dollar value of oil prices. Other forces could have additional upward or downward impact on prices.

I stand by my criticism of Guy's original assertion ( and by extension , your reformulation ) .

Guy's statement contains two elements . First , he asserted the existence of a - 1.0 coefficient of correlation between the dollar-euro exchange rate and the price of oil - when the dollar weakens against the euro , the price of oil increases . Please note that my criticism of Guy's assertion does not rest ( as you supposed ) on a claim that it cannot explain all of the rise in the price of oil . Two , he asserted , that the slope of the regression line has a unity value - if the dollar depreciates by 20% against the euro , then the price of oil increases by 20% . Both these claims are false .

The price of oil is set in world markets. Therefore when the dollar depreciates by 20% relative to the euro, it must be that the ratio of oil prices in dollars vs euros must also increase by 20%. Otherwise there would be a risk-free profit opportunity, buying oil in dollars and selling it in euros.

You are correct (and I was incorrect) that because of other cross-rates it is possible that the dollar price of oil would increase by less than 20%. However, the change in price ratio would be 20%. And the price of oil in dollars relative to the price in other currencies would move exactly by the same amount as the dollar's movement relative to those currencies.

I don't think any of this undermines my original argument.

Guy

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So Guy , is Jan correct in his supposition that you were , contrary to appearances , talking about oil's intrinsic value ??

Again, I was abusing technical language and assuming that I would be understood. I'm not posting under ideal circumstances.

Edit: In retrospect, I wish I had said "market value as expressed in any given currency" in place of "intrinsic value". Haste is the enemy of accuracy.

Edited by J Larsen
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The price of oil is set in world markets. Therefore when the dollar depreciates by 20% relative to the euro, it must be that the ratio of oil prices in dollars vs euros must also increase by 20%. Otherwise there would be a risk-free profit opportunity, buying oil in dollars and selling it in euros.

You are correct (and I was incorrect) that because of other cross-rates it is possible that the dollar price of oil would increase by less than 20%. However, the change in price ratio would be 20%. And the price of oil in dollars relative to the price in other currencies would move exactly by the same amount as the dollar's movement relative to those currencies.

I don't think any of this undermines my original argument.

I'm afraid it does .

Your initial claim* was about the effect of dollar-euro depreciation on the dollar price of oil , not the effect of dollar depreciation on the ratio of the dollar price of oil to the euro price of oil . This new assertion about ratio adjustments does nothing to support your initial claim , and what's more , your statement of it is incorrect . A 20% dollar-euro depreciation does not result in a 20% increase in the ratio of oil prices in dollars vs. euros , but rather a 25% increase , and then only if the depreciating currency is in the numerator of the ratio . If the dollar price of oil is in the denominator , then a 20% dollar depreciation decreases the ratio by 20% . In any event , the ratio adjustments are merely a consequence of the depreciation itself and are not predictive in the way you claim of whether or how much the actual dollar price of oil will increase which was the substance of your initial claim . It's not because of "other cross-rates" that the dollar price of oil can increase more or less than 20% for a 20% dollar/euro depreciation , but because research has shown that the coefficient of correlation is - 0.7 and not - 1.0 , meaning that the dollar price of oil needn't increase at all in such a case , though more often than not it does .

*

1) Currencies are just measuring units. If you halve the size of the measuring units, what you are measuring doesn't double in size. To tie it to currencies and oil -- if the dollar's nominal exchange rate depreciates by 20%, then the dollar price of oil will increase instantaneously by about 20%(emphasis mine). This will be true if oil is priced in euros, dollars or coconuts. If oil is priced in dollars, you are selling it, and you want the income in euros, you can easily and quickly carry out a foreign exchange operation to achieve your goal. What this means for oil-producing countries is that it doesn't matter in which currency oil is priced. Regardless of whether oil is priced in euros, dollars or coconuts, a 20% depreciation of the dollar against the euro (or coconut) will cause the price of oil to go up by 20% in dollars and remain unchanged in euros (emphasis mine).
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