Streetwise Professor

January 20, 2016

Rube Krugman Argues From a Price Change, With Predictably Absurd Results

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 1:50 pm

The oil collapse continues apace, after a one day breather on Monday. As I write, WTI and Brent are off almost 8 percent. Equity indices around the world are going in the same direction.

This recent co-movement between crude (and other commodities, especially non-precious metals) has unleashed torrents of twaddle. One of the most egregious pieces thereof was a recent Krugman column:

When oil prices began their big plunge, it was widely assumed that the economic effects would be positive. Some of us were a bit skeptical. But maybe not skeptical enough: taking a global view, there’s a pretty good case that the oil plunge is having a distinctly negative impact. Why?

Well, think about why we used to believe that oil price declines were expansionary. Part of the answer was that they reduced inflation, freeing central banks to loosen monetary policy — not a relevant issue at a time when inflation is below target almost everywhere.

Beyond that, however, the usual view was that falling oil prices tended to redistribute income away from agents with low marginal propensities to spend toward agents with high marginal propensities to spend. Oil-rich Middle Eastern nations and Texas billionaires, so the story went, were sitting on huge piles of wealth, were therefore unlikely to face liquidity constraints, and could and would smooth out fluctuations in their income. Meanwhile, the benefits of lower oil prices would be spread widely, including to many consumers living paycheck to paycheck who would probably spend the windfall.

Now, part of the reason this logic doesn’t work the way it used to is that the rise of fracking means that there is a lot of investment spending closely tied to oil prices — investment spending that has relatively short lead times and will therefore fall quickly.

Where to begin? I guess the place to start is to note that Krugman commits a cardinal economic error (you’re shocked, I’m sure): he argues from a price change. What is frightening is that if you believe his characterization of the received wisdom in macroeconomics, this is the standard way of thinking about these things in macro.

Prices do not move exogenously. Prices can go down because of supply shocks. They can go down because of demand shocks. The price movement is the same direction, but the implications are very different. In particular, the implications for co-movements between oil prices and asset prices are very different. You cannot analyze based on the fact of the price change alone: your analysis must be predicated on what is driving that change.

A price decline because of a favorable supply shock is generally positive for the broader world economy. Yes it is bad for oil producers, but especially for advanced and most emerging economies who are oil/commodity shorts, a supply-driven price decline is beneficial and should be associated with higher stock prices, economic growth, etc. The production possibility frontier shifts out, leading to higher incomes overall although in a world with incomplete risk sharing there are distributive effects. But the adverse consequences for producers are almost always swamped by consumer gains.  In this scenario, growth and asset prices on the one hand, and commodity prices on the other, move in opposite directions.

Things are very different for demand shocks-driven price changes. A price decline because of an adverse demand shock is generally negative for the broader world economy, because it is a weakening world economy that is the major source of the demand decline. This is a matter of correlation, not causation. Causation runs from a weakening economy to lower demand for oil (and other commodities) to lower commodity prices and lower asset prices.  Oil price (and asset price) changes are an effect not a cause.

The current situation is much closer to the latter case than the former. Yes, there have been oil production increases in the last couple of years, but if world economic growth had continued on its pre-mid-2014 pace, demand would have grown sufficiently to absorb this increase. In fact, the decline in oil and other commodity prices starting around June 2014 occurred right about the time that world growth forecasts declined appreciably. Subsequent months have seen a litany of bad growth news from the main sources of commodity demand growth in the boom years, most notably, of course, China. And the news from China keeps getting worse. This is reflected in cratering stock prices there, and other indicia of economic activity. (Notably all of these indicia are pretty much non-official. Official Chinese statistics should be nominated for the next Nobel Prize in Fiction.)

But rather than go back to basics, Krugman assembles a Rube Goldberg contraption to explain what is going on. And of course, austerity and the liquidity trap play a starring role:

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

Since because of his cardinal error Krugman does not identify what caused the price decline that begins his chain of “reasoning,” it’s hard to understand fully what he means. The most charitable interpretation is that there was a favorable supply shock that was so big that it caused such a large price decline in oil that this caused world “aggregate demand” to decline because of the severe adverse consequences on indebted and liquidity constrained producing countries and companies.

Inane. For one thing, these economies and sectors are very small in comparison to the world economy. Commodity producing countries have historically suffered major financial crises with little, if any, effect on growth world-wide, or on asset prices world-wide. The US oil and gas sector has also undergone some severe crises (e.g., 1986-1987) with limited fallout on US and world growth: the impacts tended to be concentrated regionally in the producing states, such as Texas. Not much fun there, but the rest of the country and the world didn’t much notice. In fact, they benefited from the favorable oil supply shock.

For another, even if there is some asymmetry between the “liquidity constraints” of producers and consumers, Krugman has been arguing strenuously that US and European consumers are liquidity constrained, hence his constant attacks on austerity. In Krugman’s argue-from-a-price-change story, that liquidity constraint has eased, and therefore one would expect to see improvement in consumption growth in places like the US, but the reverse is in fact true. The US economy is slowing rather noticeably.

No. The back-to-basics-trace-the-cause-of-the-price-change story is much more plausible. And here’s the irony. The epicenter of the commodity demand and world growth shock is China, which has binged on credit stimulus since 2009 in a way that Krugman should approve. But that cannot go on forever, and indeed, the main source of problems in China is the recognition that it can’t go on forever. China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase. How bad it is depends on how well the Chinese handle it. Given their mania for central control, I do not believe they will handle it well.

Macro panjandrums, like Oliver Blanchard, are puzzled, because official data do not yet reflect any large decline in growth. But that’s because official data are backward looking, and markets look forward relentlessly. They are signaling current and future problems, which official data will eventually validate. (And that’s when the data aren’t made up, as is notoriously the case in China.)

Commodity prices are particularly important, because commodities are consumed in the here and now. When demand declines, consumption declines, and prices decline contemporaneously. For all the talk about financialization, that can’t overcome the decisions of billions of commodity consumers around the world. Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems. You don’t need Rube Krugman contraptions to explain that.

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  1. > Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems.

    Hi Professor. If you’re so inclined, I would appreciate a future post expounding your thoughts about your meaning of ‘broader economic problems’. I ask because I find your perspective unique and often it helps me cut through the noise to better understand complex systems at work. Thank you in advance.

    Comment by Robert D. — January 20, 2016 @ 3:33 pm

  2. Ah, the joys of national income accounting!!!!!!!! How much of China’s growth is the annualized rental “value” of empty buildings? How much of it is sheer fiction? God how I hated Macro economics and econometrics – stochastic heuristic models were more accurate, especially when adjusted for supply and demand shocks, but despised because one couldn’t run scenarios, changing inflation scenarios, etc.

    Talk of price leading the analysis.

    Comment by Sotos — January 20, 2016 @ 4:19 pm

  3. @Sotos-If past investments in real estate, infrastructure etc., were marked to market, Chinese national income would be far lower, for the reasons that you note. National income accounting is a classic example of counting costs as benefits.

    The way this all comes home to roost is that these bad investments are largely debt financed. Because the income these investments generate is inadequate to service the debt, sooner or later a financial crisis (complete with bank failures) occurs, and the past losses are realized and additional losses are incurred due to the disruption of the financial system. For a while the realization of loses can be deferred by bringing the bad debt onto government balance sheets, but that will inevitably fail eventually. It is just deferring, rather than eliminating, the reckoning, and making it worse when it occurs.

    The ProfessorComment by The Professor — January 20, 2016 @ 7:07 pm

  4. Thanks @Robert.

    The broader economic problems change over time. In the 2008-2009 situation, it was a decline in real estate prices in a world where real estate investments were highly leveraged. There are some parallels to the current situation in China. Not just real estate, but industrial capacity and infrastructure have been overbuilt and funded with debt. Chinese growth will (or already has) slow dramatically, with a non-trivial probability of a banking crisis. I hope to expand on this later, but hope this is helpful for now.

    The ProfessorComment by The Professor — January 20, 2016 @ 7:20 pm

  5. Impressive analysis, prof. Thank you. I look forward to that piece on the pending banking crisis.

    “China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase.”

    You mean everything that has happened so far has simply been preliminary to a pending ‘main event’? Cripes. I’ll get the popcorn.

    Comment by Ex-regulator on lunch break — January 21, 2016 @ 12:54 am

  6. Professor,

    According to Energy Intelligence Group Oil Product Demand Data (OPCBRTOT on BBG) global oil demand did not decrease either in 2015 or in 2014. As a matter of fact, annual growth was the highest last year than any time for the past 15 years, except for the rebound in 2010 after the 2009 slump. On a little longer horizon, demand grew 1,6 pct saar since end of 2010. In the meantime, supply (OPCBTSUP), however, grew 3 percent since the end of 2010, which is the strongest 5-yr growth since 1995 (the first data point in this series). Let’s not forget either, that US oil production almost doubled in 9 years (from a little more than 5 mn bpd in 2005 to almost 10 mn at the end of 2014, making the country largely equal with Saudi Arabia in terms of output.

    I like the articles which point to where Paul Krugman with his oversimplified way of looking at complex things is wrong, but data do not support your current argument. Or I am just looking at the wrong numbers.


    PS: China is a trouble, and I cannot even comprehend the extent of their problems. I hope Xi Jinping does.

    Comment by Peter — January 21, 2016 @ 7:18 am

  7. You seem so sure that China is the culprit here, yet you assert that you can’t trust the data. Seems at odds. China’s economy has been in decline since 2010-2011, the pace at which can be debated, but a decline none the less, well before the pivot down of oil prices. Ask the other China levered commodities companies what they have seen (BHP, Rio, et al). Why are you so quick to dismiss the supply side of the equation here? Perhaps that is for a future post. China is clearly over levered, significantly unbalanced towards investment than other large economies, and will have a painful reckoning over the next decade (see, but China also far too often seems to be the convenient excuse for all that ails the world.

    Comment by KDV — January 21, 2016 @ 8:35 am

  8. Unfortunately, you are very wrong when it comes to supply and demand in the oil market. According to the IEA, global oil supply (crude + liquids) increased by just 0.4 MMbbl/day in 2013, an then an incredible 2.4 MMbbl/day in 2014 and another 2.5 MMbbl/day. The general rule of thumb is that 1.5 MMbbl/day of growth in oil demand is a pretty good year. Yes, 2014 saw lower demand growth (again according to the IEA) of about 0.8 MMbbl/day, which accelerated to an impressive 1.8 MMbbl/day in 2015. Now, if you just take the difference between those annual numbers and assume that is the annual stock change, oil stocks would have risen by 580 MMbbl in 2014 and another 250 MMbbl in 2015. Unfortunately, that doesn’t seem to be correct; the IEA says commercial stocks (government stocks have been unchanged) rose from 2.632 billion barrels in November 2013 to 2.735 Bbbls in November 2014 (about 0.3 MMbbl/day) and to 2.982 Bbbls in November 2015 (about 0.7 MMbbl/day). Now, all those ‘missing barrels’ from 2014 could have gone into storage in developing economies (and some surely did in China), but the magnitude suggests that is unlikely. Instead, the IEA seems to be underestimating demand, which is notoriously difficult to measure. The real story is an rapid increase in production from the U.S. and Canada (+1.4 MMbbl/day from Q4 2013 to Q4 2014) ran head-on into a major increase in Iraqi output (+0.6 MMbbl/day in Q4 2014; +0.6 MMbbl/day full-year 2015 vs. full-year 2014) and Saudi output (+0.6 MMbbl/day full-year 2015 vs. full-year 2014), pushing prices lower. I think you can argue about whether or not this has provided a boost to growth (I think it probably has, but other factors, such as the slump in other commodities related to very real demand-side issues in China, have combined to offset the benefit), but its disingenuous to argue Krugman is starting from the wrong side of the price change.

    Comment by Mitch — January 21, 2016 @ 9:00 am

  9. Almost every other analysis I’ve read suggests that the recent collapse in oil prices has been driven mainly by supply factors: the rise of shale oil, Saudi Arabia-led OPEC deciding to pump all out in the face of declining prices in a bid to drive out high-cost producers, and Iran coming online as sanctions are lifted. To explain the sharp fall in prices we’ve seen as demand-driven, demand would have had to crater to such an extent that it would be obvious in lots of other indicators. It seems the consensus is that oil consumption in China rose last year, despite the slowing economy. If you allow that the movement has been mainly supply-driven then the rest of Krugman’s analysis follows.

    Comment by o. nate — January 21, 2016 @ 9:08 am

  10. @Ex-reg. Thanks. Sadly, I think that’s the case. Maybe the Chinese will get lucky and finesse the transition, but I highly doubt it.

    I’m sure that’s not great news for y’all Down Under.

    The ProfessorComment by The Professor — January 21, 2016 @ 2:38 pm

  11. No, not good, but we’ve had plenty of warning by now.

    The upside is that, for those of us who have eyes to see and ears to hear, and who have hedged out our exposure, it will mean that there will be some quality assets being sold for a song when the reckoning is done.

    Comment by Ex-regulator on lunch break — January 21, 2016 @ 11:45 pm

  12. @Professor, do you think the Chinese will go the Russia way and use a small victorious war to distract attention from the realization of losses formerly known as miraculous growth?

    Comment by Ivan — January 22, 2016 @ 2:43 pm

  13. Thanks, Professor. You can always be trusted to give an even-handed and clear-minded analysis. One thing is certain no matter what happens next, Krugman will keep claiming that his position has been vindicated and that he’s been right all along.

    Comment by aaa — January 22, 2016 @ 8:59 pm

  14. Ah, more Keynesian nonsense from that fool. The Saudis, et al, are merely sitting on piles of cash…stuffed into their mattresses. Krugnuts is either senile or an idiot, I can’t really tell which.

    Comment by Methinks — January 25, 2016 @ 7:59 am

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