Petrodollars and the Cycle of Financial Bubbles Here We Go Again

Reasonably Foreseeable Consequences Oil, Dollars, Debt, and Crises

Petrodollars and the Cycle of Financial Bubbles Here we go again

Mahmoud A. El-Gamal, mostly from book with Amy M. Jaﬀe

Department of Economics, Rice University and James A. Baker III Institute for Public Policy

March 2, 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 1 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Hyman Minsky on Convenient Theories and Facing Reality

A theory that denies what is happening can happen, sees unfavorable events as the work of evil outside forces (such as the oil crisis) rather than as the result of characteristics of the economic mechanism, may satisfy politicians’ need for a villain or scapegoat, but such a theory oﬀers no useful guide to a solution of the problem

...

The economic instability so evident since the late 1 960s is the result of the fragile ﬁnancial system that emerged from cumulative changes in ﬁnancial relations and institutions of the years following World War II.

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 2 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Coincidence of High REAL Oil Prices with Financial Crises Crises Severest 1850s-70s (before gold standard), and 1970s– (after Bretton Woods)

120

100

Brent Crude Price in 2007 Dollars 40

0 1860 1880 1900 1920 1940 1960 1980 2000

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 3 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Outline

1 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Financial Imbalances and Petrodollars

2 Oil, Dollars, Debt, and Crises Transmission Mechanism Managing the Cycle

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 4 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Self-Perpetuating Cycle, Magniﬁed during Financial Crises Decline in Demand Decline in Prices Decline in Investment Price Spike @ Recovery ⇒ ⇒ ⇒

World 5 GDP growth

0 World Energy Use growth

!2 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 5 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Lag in Oil-Price Responses, Lag in Capacity Development Geopolitical Events Cause Oil Prices to Over Compensate

1000 140

900 120 800 Gold Prices (left axis)

700 100

600 80

500

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

200 20 Crude Oil Prices 100 (right axis)

0 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 time

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 6 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars The Oil Revenue (Petrodollar) Problem Price stabilization ampliﬁed oil revenue cycle ⇒ 1 During the upswing of the cycle growth energy demand inventory oil price ↑ ⇒ ↑ ⇒ ↓ ⇒ ↑ To ameliorate oil-price and real-business cycles, revenue cycle is ampliﬁed oil production/sales oil revenues ↑ ⇒ ⇑⇑

There is no “good price” to defend in the short run ⇒ 2 During the downswing of the cycle growth energy demand inventory oil price ↓ ⇒ ↓ ⇒ ↑ ⇒ ↓ To ameliorate oil-price and real-business cycles, revenue cycle is ampliﬁed oil production/sales (?) oil revenues ↓ ⇒ ⇓

Asymmetric response: OPEC members cheat on their quotas

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 7 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars The Oil Revenue (Petrodollar) Problem Price stabilization ampliﬁed oil revenue cycle ⇒ 1 During the upswing of the cycle growth energy demand inventory oil price ↑ ⇒ ↑ ⇒ ↓ ⇒ ↑ To ameliorate oil-price and real-business cycles, revenue cycle is ampliﬁed oil production/sales oil revenues ↑ ⇒ ⇑⇑

Asymmetric response: OPEC members cheat on their quotas

30 OPEC production 25

15 OPEC quota

10 Saudi production

Saudi quota OPEC & Saudi Quotas and Production (millions B/Day) 0 1980 1985 1990 1995 2000 2005 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 8 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Outline

1 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Financial Imbalances and Petrodollars

2 Oil, Dollars, Debt, and Crises Transmission Mechanism Managing the Cycle

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 9 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Limited Absorptive Capacity and Petrodollar Problem I. Real Estate Bubbles

80 3500

70 3000

60 2500

50 2000 Crude oil price (left axis) 40 1500

30 Real estate index 1000 WTI Crude Price ($US/BBL) (right axis)

20 500 Kuwait AlShall Real Estate Index ($US)

10 0 1999 2001 2003 2005 2007

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 10 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Limited Absorptive Capacity and Petrodollar Problem II. Stock Market Bubbles

900

800 Saudi Arabia

700

600

500

400

Jordan 300

200

100 Egypt

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 11 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Limited Absorptive Capacity and Petrodollar Problem II. Poster-child bubble: Emaar Properties PSJC Share Prices

20 Emaar Share Price (AED) 15

0 2003 2004 2005 2006 2007 2008 2009 Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 12 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Financial Imbalances Ampliﬁed by Recycled Petrodollars Contagion + Petrodollar Flows Have Contributed Substantially to Bubbles & Inﬂation

x 105 5

3 China

Saudi Arabia + Kuwait 1

First petrodollar Second petrodollar surge, 80s debt crisis Surge −1 1975 1980 1985 1990 1995 2000 2005 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 13 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars 1980s Correction for Financial Imbalances Revaluation of the Japanese Yen

400

350

300

250

200 Louvre Accord Yen per Dollar February 22, 1987

Plaza Accord 150 September 22, 1985

100

50 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 14 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Japan’s Lost Decade Enabled ASEAN Export-Led Growth

5 Japanese GDP growth rae (%)

!5 1970 1975 1980 1985 1990 1995 2000 2005 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 15 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Chinese Strategy So Far Continuation of Undervalued Currency

Mainland China PR GDP growth (%) 30

10 Chinese growth (%) and exchange rate (per $)

5 Chinese Exchange Rate (per US$)

0 1975 1980 1985 1990 1995 2000 2005 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 16 of 26 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Oil, Dollars, Debt, and Crises Financial Imbalances and Petrodollars Beginning of the End for the Dollar Era? Compare to British Pound A Century Ago + Geopolitically-Motivated Attacks on Dollar

110

U.S. Nominal Effective Exchange Rate 100

80 Percentage of Official Reserves in US $

50 1994 1996 1998 2000 2002 2004 2006 2008

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 17 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Outline

1 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Financial Imbalances and Petrodollars

2 Oil, Dollars, Debt, and Crises Transmission Mechanism Managing the Cycle

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 18 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Cyclical Petrodollar Recycling and Financial Crises

1 Procyclical feedback mechanism during booms

growth oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts Reasonably Foreseeable Consequences Financial Transmission Mechanism Oil, Dollars, Debt, and Crises Finance and the Dollar-Era Crisis recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ Cyclical↑ ⇒ Petrodollar Recycling and Financial Crises

5 Recovery: low energy cost + expansionary policies growth 1 Procyclical feedback mechanism during booms ⇒ ⇒ Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubblesgrowth 19 of 26 oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts

recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ ↑ ⇒

5 Recovery: low energy cost + expansionary policies growth ⇒ ⇒ c Mahmoud El-Gamal and Amy Jaﬀe – Abu Dhabi talk, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 13 of 21 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Cyclical Petrodollar Recycling and Financial Crises

1 Procyclical feedback mechanism during booms

growth oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts

recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ ↑ ⇒

1 Procyclical feedback mechanism during booms

growth oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts

recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ ↑ ⇒

1 Procyclical feedback mechanism during booms

growth oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts

recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ ↑ ⇒

1 Procyclical feedback mechanism during booms

growth oil price Petrodollar ﬂow interest rates growth ⇒ ↑ ⇒ ⇑ ⇒ ↓ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

2 Hubris (80’s: countries don’t go bankrupt; 00’s: house prices don’t fall !)

Petrodollars interest rates , asset prices leverage asset prices ⇑ ⇒ ↓ ↑ ⇒ ↑ ⇒ ↑

3 Eventually (Minsky moment; Ponzi ﬁnance)

high cost slowdown bad loans Crisis or interest rates recession ⇒ ⇒ ⇒ ↑ ⇒

4 Procyclical feedback mechanism during busts

recession oil price Petrodollar ﬂow interest rates recession ⇒ ↓ ⇒ ⇓ ⇒ ↑ ⇒

5 Recovery: low energy cost + expansionary policies growth ⇒ ⇒ c Mahmoud El-Gamal and Amy Jaﬀe – Abu Dhabi talk, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 13 of 21 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle The Laws of Supply and Demand Have Not Been Abrogated American Consumers React to Retail Gasoline Prices

9500

9000

8500 month moving average) ! 8000

7500

7000

6500

6000 U.S. Automobile Gasoline demand (1,000 b/d, 12 5500 1970 1975 1980 1985 1990 1995 2000 2005 2010

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 20 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle The Laws of Supply and Demand Have Not Been Abrogated China has a cycle too

China 16 GDP growth

China 0 Energy!demand growth

!2 1970 1975 1980 1985 1990 1995 2000 2005

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 21 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Outline

1 Reasonably Foreseeable Consequences Real, Energy, and Oil-Revenue Cycles Financial Imbalances and Petrodollars

2 Oil, Dollars, Debt, and Crises Transmission Mechanism Managing the Cycle

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 22 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Managing the Cycle

Commodities Markets: Speculators amplify the price/revenue cycle Reregulate commodity-derivatives markets Use strategic reserves to punish speculators requires international cooperation Financial Markets: Leverage makes bubbles possible Volcker rules against nonbank banks ++ Stop bailouts for banks, sukuk, etc. moral hazard ⇒ Capital controls, sterilization of inflows Sovereign Wealth Funds: Procyclical investment is unwise The primary mandate should be stabilization Middle East SWFs should lose money during boom Countercyclical financial and real options Middle East Economies: Industrialize, differentiate to integrate

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 23 of 26 Reasonably Foreseeable Consequences Transmission Mechanism Oil, Dollars, Debt, and Crises Managing the Cycle Managing the Cycle

Mahmoud El-Gamal’s talk, Abu Dhabi roundtable, March 2, 2010 Petrodollars and the Cycle of Financial Bubbles 23 of 26