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Testing Goldilocks from two sides

Image: Jacob Peter Gowy

The children’s story of Goldilocks famously gave astronomy the “Goldilocks Zone” – the band around a star where it is not too hot and not too cold for water to exist in liquid form.  More recently, the idea of a Goldilocks Zone has been introduced to the economics of oil.  The idea being that – at least until recently – there has been a Goldilocks oil price zone that is high enough for oil producers to make a profit, but low enough not to crush economic demand.  The problem is that, as with porridge (before you try it) there is no way of knowing exactly where the Goldilocks zone actually is.

Until recently it was assumed that the ideal price was somewhere in the zone $40-$60 per barrel.  That was until OPEC and Russia got together to limit output.  Today, oil prices have settled around $70 per barrel; prompting fears that the upper limit of the Goldilocks Zone is being tested.  Indeed, given that the full impact of higher oil prices can take time to be felt in the wider economy, $70 per barrel may already be too high.  As Julian Lee at Bloomberg notes:

“While higher crude prices would naturally be expected to boost spirits in the oil-dependent economies of the Middle East and elsewhere, they may have a chilling effect elsewhere. The growth of U.S. gasoline demand has already started to slow after pump prices rose late last year, and prices are still heading up.

“If crude reaches $80 a barrel by the middle of the summer driving season, those gasoline prices could be pressing $3.30 a gallon. [OPEC spokesman] Al-Falih might not have seen any demand impact yet, but that could change very quickly.”

While the OPEC/Russia output deal was intended to drive oil prices up to $70 per barrel, Saudi Arabian greed appears to be kicking in according to Nick Cunningham at Oil Price:

“Saudi Arabia is rumored to want oil prices at $100 per barrel, but if prices rise that high, it could sow the seeds of the next downturn…  in the past decade, while oil prices have surpassed $100 per barrel for periods of time, they didn’t stay there for very long. In 2008, when oil nearly hit $150 per barrel, it was quickly followed by the financial crisis and a deep U.S. recession. Then, the period between 2011 and 2014, when oil was north of $100 per barrel, U.S. shale crashed the market with a wave of fresh supply.

“If Saudi Arabia aims to drive up prices to triple-digit territory once again – and to be sure, that is only a rumor at this point – there are plenty of ways that could merely create the conditions for another bust.”

Whether or not we get a full-blown economic crash will probably depend on another Goldilocks calculation on the part of central banks.  The big four –US Federal Reserve, European Central Bank, Bank of Japan and Bank of England – are each determined to raise interest rates back to some undefined “normal” while simultaneously reversing quantitative easing.  Implicit in their machinations will be some estimate of a Goldilocks Zone where interest rates are “just right” – not too low to generate inflation but not too high to crash the economy.

The trouble with interest rate policy, however, is that it is perversely intended to overshoot the Goldilocks Zone to provide the central banks with the means of undershooting it later on.  As Richard Partington in the Guardian reports:

“According to the Institute for Public Policy Research (IPPR), the odds of a recession once every 10 to 15 years mean Threadneedle Street needs additional firepower for when the economy next begins to falter.

“As the Bank considers raising interest rates above 0.5% from next month for the first time since the last recession almost a decade ago, the report suggests they should be set closer to 5% to give the central bank any chance of keeping the economy running smoothly.

“In all three of the last recessions dating back to the early 1980s, interest rates were cut by 4.5%-5% in order to sustain economic demand.”

This begs the question of what happens to the real economy in the event of oil prices and interest rates breaking out of their respective Goldilocks Zones simultaneously.  Spikes in oil prices have preceded almost all of the major recessions in modern times.  Despite being fundamentally deflationary, central bank economists have invariably believed them to be inflationary; and have raised interest rates in response – the economic equivalent of throwing petrol on an already raging fire.  This time around, it appears that oil producers and central banks intend breaking out of their respective Goldilocks Zones independently of one another and with little consideration of the health of the real economy.

Both interest rates and oil are what are known as inelastic items – we have no flexibility over paying them.  If the cost of servicing debts or the cost of fuel and transport increase, we have little choice other than to suck it up… until we default.  In the absence of additional currency being pumped into the economy (the reverse of what is currently happening) our only – collective – option is to shift our spending away from whatever elastic purchases we are still making; further exacerbating the “retail apocalypse” that is decimating the real economy.  Then, at least, we will have a better idea of where the upper limit to the economic Goldilocks Zone was.  But only after – like Icarus – we have flown too close to an economic fireball that caused us to crash and burn.

As you made it to the end…

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