Memo to market: High oil prices are DE-flationary

As the European Central Bank (ECB) prepares to raise interest rates to prevent inflation, the bank cites rising commodity prices, particularly oil prices, as a sign of that inflation. What the bank and other market participants don't seem to understand is that high commodity prices and, in particular, high oil prices are deflationary.

The logic is so simple it's hard to understand why smart people with advanced degrees can't see it. Commodities, particularly oil, pull money away from other sectors of the economy. When people are forced to choose between paying for heat and gasoline or paying the mortgage, they pay for heat and gasoline. Cars don't budge without gasoline (unless you can afford an electric one) and most people need their cars to get to work. The heat can be turned off rather quickly by the utility company in comparison to the glacial pace of a mortgage foreclosure that can take many months and sometimes more than a year.

This situation is particularly problematic because it pulls money out of the financial sector. And, despite all the nonsense about the financial industry being on the mend, the industry is actually becoming more and more vulnerable by the day as it increases its exposure and leverage to financial and commodity markets. The speculative animal spirits of the banks, hedge funds and other large investors, buoyed by all the virtually free money available for borrowing and huge taxpayer-financed injections into zombie banks, may now be hurtling us toward another jaw-dropping financial catastrophe. As Hyman Minsky might put it, stability and prosperity lead to instability and crisis as market participants become more and more emboldened on the upswing creating the illusion that all is well. Then, when prices and credit expansion go beyond what the economy can sustain, a decline ensues that is often dramatic as confidence suddenly shifts to revulsion and fear.

As housing prices continue to sink, the immense amount of bad mortgage debt still floating around the financial system becomes even more putrid than before. Someday the institutions which hold the debt will have to stop pretending that they are going to get paid back. But the prelude to that will be deflation brought on by the high prices of oil and commodities which tend to depress economic activity as household spending is reserved for essentials rather than discretionary items. As the animal spirits in the markets get dampened by the realities in the economy, the stage is set for a crisis--a turning point when confidence and liquidity turn into fear and illiquidity as big investors try to exit positions all at the same time.

Compounding the deflationary forces inherent in high commodity prices are severe cutbacks by states hit by declining revenues, federal cutbacks, and austerity programs now being implemented across Europe. All of these add to the deflationary juggernaut.

It is certainly possible that commodity prices including oil could rise much higher before the effects described above finally topple the economy. And, it's possible that those prices could moderate and fall gently in a way that might lengthen any economic recovery under way. But it does seem that we are much closer to a top in commodity prices than to a bottom.

The U.S. Federal Reserve Board seems to agree that high oil prices could be deflationary. One of the Fed governors indicated that the Fed's attempts to boost the economy by buying government bonds (and thus lowering long-term interest rates) could be extended if oil prices continue to rise.

I don't know what the interest rate policy for the ECB or the Federal Reserve should be. I think neither have good options. I do know that 10 of the last 11 recessions were preceded by oil price shocks. And, this time we are dealing with shocks not only in oil, but also in food, just as we did in 2008. And, I don't have to remind readers what happened after that.

Will we see a repeat of 2008 in 2011? Mark Twain used to say that "history doesn't repeat itself, but it does rhyme." So far the stanzas of 2011 seems to be rhyming quite well with those of 2008. There have been price spikes in food and oil followed by denials that these could derail the economy coupled with unrest on the streets of many countries related in part to high food and energy costs. But I'd say look for an unexpected divergence between the two periods. Whether that divergence turns out to be detrimental or felicitous will, however, not change the fact that high commodity prices are deflationary.