Business and Financial Cycles Post-Bretton-Woods Problems

Energy Prices, Business Cycles, and Financial Crises The Argument for Cycle Attenuation

Mahmoud A. El-Gamal & Amy M. Jaffe

Rice University & Baker Institute for Public Policy

October 2008

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Financial Crises and Energy Prices Post-Bretton-Woods Problems The Role of Recycled Petrodollars Frequency and Causes of Crises Globalizations Past and Present

Reckless Lending Era 1850s–1870s: Major and banking crises Gold Standard Era 1880–1913: Some currency and banking crises Between Wars 1919–1939: Numerous currency and banking crises Bretton Woods 1945–1971: Many currency crises but no banking crises Era 1973–present: Numerous currency & many banking crises

Trade surpluses, Reckless Lending, and Recent Crises 1980–present:

1980s Scandinavia & Latin America: Reckless lending fueled bubbles that collapsed with oil prices, leading to currency and banking crises 1990s Japan, Asia: Supporting the Dollar and reckless lending fueled bubbles, which burst with tightened , banking crisis 2000s Contagion + record U.S. debt pose substantial global-systemic risk

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Financial Crises and Energy Prices Post-Bretton-Woods Problems The Role of Recycled Petrodollars Coincidence of High Oil Prices with Financial Crises Crises Severest 1850s-70s (before gold standard), and 1970s– (after Bretton Woods)

120

100

80

60 Brent Oil Price in 2006 40

20

0 1860 1880 1900 1920 1940 1960 1980 2000

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Financial Crises and Energy Prices Post-Bretton-Woods Problems The Role of Recycled Petrodollars Asian Savings Glut and The Return of Recycled Petrodollars Contagion + Petrodollar Flows Have Contributed Substantially to Bubbles & Inflation

x 1011 2.5

2

1.5 China

Kuwait 1 + Saudi Arabia

0.5

0

−0.5 Capital & Financial Accounts net Outflows (U.S.$, IMF BOP)

−1 1975 1980 1985 1990 1995 2000 2005

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Financial Crises and Energy Prices Post-Bretton-Woods Problems The Role of Recycled Petrodollars Cyclical and Financial Crises

Feedback mechanism during booms growth (lag) ⇒ oil price ↑ ⇒ Petrodollar flow ↑ ⇒ interest rates ↓ ⇒ growth

Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !) Petrodollars ↑ ⇒ interest rates ↓ , asset prices ↑ ⇒ leverage ↑ ⇒ asset prices ↑

Eventually (Minsky moment; Ponzi finance) high cost ⇒ slowdown ⇒ bad loans ⇒ Crisis, interest rates ↑ ⇒

Feedback mechanism during busts recession ⇒ oil price ↓ ⇒ Petrodollar flow ↓ ⇒ interest rates ↑ ⇒ recession

Low cost of production + monetary and fiscal policies (lag) ⇒ + geopolitical strife (lag) ⇒ oil price ↑

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation Lag in Oil-Price Responses, Lag in Capacity Development Declining Real Oil Prices Precede Jumps

1000 140

900 120 800

Gold Prices 100 700 (left axis)

600 80

500

60 400 Gold Price ($US/T.Ounce) Crude Oil Price ($US/BBL) 300 40

200

Crude oil prices 20 100 (right axis)

0 0 1970 1975 1980 1985 1990 1995 2000 2005 2010

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation The Absence of Automatic Exchange-Rate Cycle Attenuation Trade Deficits, Debts, Debased Dollars, and Oil

4 x 10 70 8

7 60

6 Crude oil price 50 (left axis) 5 U.S. trade deficit 40 (right axis) 4

30 3

2 20 Price ($US/BBL) 1 US trade deficit ($million USD)

10 0

0 −1 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation Self-Perpetuating Cycle, Magnified during Financial Crises Amy’s Presentation Will Cover Current Decline in Demand

7

6

World 5 GDP growth

4

3

2

1

0 World Energy Use growth

−1

−2 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation China’s Dependent The Dangerous Mirages of “Economic Miracles”

18

China 16 GDP growth

14

12

10

8

6

4

2

China 0 Energy−demand growth

−2 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation Beginning of the End for the Dollar Era? Compare to British Pound A Century Ago

x 106 4.5 110

U.S. Nominal 4 Effective Exchange Rate 100

3.5

3 90

2.5 Total Reserves All Countries 80 Percentage of Official Reserves in US $ 2 Reserves (millions of SDRs) 1.5 70

1

Reserves held by 60 Oil!Exporting Countries 0.5

0 50 1940 1950 1960 1970 1980 1990 2000 2010 1994 1996 1998 2000 2002 2004 2006 2008

Total Official Reserves (millions of SDRs) Percentage of Official Reserves in U.S.$

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation Inevitable Cycle, Amplitude Ramifications Ramifications for Middle-East

Upswing amplifiers: Cheap- driven bubbles and financial crises Amplification catalyst: Amnesia/hubris: “This time is different” Downswing amplifiers: Socioeconomic & geopolitical costs

45,000 350

300 40,000

U.S. 250

35,000

200

30,000

150

25,000

Per Capita GDP PPP constant 2005 Dollrs Saudi Arabia 100

20,000 50

15,000 0 1980 1985 1990 1995 2000 2005 2010 1975 1980 1985 1990 1995 2000 2005 2010

Saudi vs. U.S. Real Per-Capita GDP Real Per-Capita Egyptian Worker

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises Business and Financial Cycles Source of The Dollar-Era Crisis Post-Bretton-Woods Problems The Cycle Continues: Need for Attenuation The Need for Counter-Cyclical SWF Investments Avoiding Extreme Fluctuations through Cycle Attenuation

Paradox 1: Middle-East Sovereign Wealth Funds invest pro-cyclically (data collected by Chhaochharia and Laeven, 2008) Focus on private equity deals in Middle East Focus on oil & gas (ADIA), financials (KIA), utilities (QIA) U.S. exposure too much (KIA) or too little (ADIA) Paradox 2: Banking crisis flight to safety led to Dollar appreciation!

Attenuate: Invest in fuel-production capacity during Diversify: Invest in alternative energy, green technology, etc. Balance: America & Middle East need to consume less and invest more, Asia needs to consume more and save less

Mahmoud A. El-Gamal & Amy M. Jaffe – London, October 27, 2008 Energy Prices, Business Cycles, and Financial Crises