Saturday, October 14, 2006

Nouriel Roubini is wrong: lower oil prices are good news for the U.S. economy

Professor Nouriel Roubini does correctly make a number of cogent arguments in his blog post entitled "Confusing Cause and Effect: Why Lower Oil Prices is [sic] Bad News for the U.S. Economy", but he also commits at least a few significant errors, so that his conclusion is not supported once his errors are stripped away.

The essence of the dedate is whether the decline in oil and other commodity prices is due to a reversal of a speculative commodities bubble or a dramatic reduction in real demand. The latter would support his conclusion, the former would not.

Put simply, he does not do a good job of eliminating speculation as the causal factor. He mentions it, but only pays it lip service and in a disparaging manner. Further, he fails to offer evidence of a reduction in demand for commodities. Since he has done neither, he has no supportable justification for his conclusion.

By definition, lower commodity prices are good for any economy. By definition. Lower costs leave consumers and businesses with more disposable income. What Professor seems to have intended was to argue a different thesis, such as whether falling commodity prices are a indicator for the strength of an economy, but he didn't state that or anything similar as his thesis.

He somehow has trouble recognizing that over the past two years or so almost all commodities were in the grips of a speculative frenzy, with hedge funds, investment banks, and all manner of promoters leading the charge. The prices of commodities futures are a major factor in the pricing of the comodities themselves, but do not directly indicate real demand for the commodities themselves. As speculators bid up futures prices, prices of the commodities go up as well. We have seen quite a number of reports even in the general as well as financial media that have recognized the eye-opening levels of speculation over the past year. This was like the stock boom in 1999 and the recent housing boom. As the saying goes, a rising tide lifts all boats. Roubini's biggest error is that he seems to believe that real economic demand is the only tide and that he refuses to recognize the "tide" effect that speculation can have in market "booms", whether it be stocks, real estate, or commodities.

My most serious complaint is that Professor Roubini commits the cardinal logical sin of confusing correlation and causality. He states:

... whenever the US and the global economy has experienced a recession oil and commodity prices sharply fell at the outset and during such recession as low global demand leads to lower commodities demand ...

It may well be true that such a correlation can be established, but correlation never automatically implies casusality. For causality, we need to identify a causal mechanism and demonstate that it holds under all conditions. Roubini's statement has the form of an immutable "law", but the data doesn't seem to support such a law-like relationship. The simple fact is that commodity prices have significant volatility and not all instances when "oil and commodity prices sharply fell" were immediately followed by a recession. The simple test here is whether oil prices have fallen sharply below their typical price during the main body of the business cycle, and the answer is clearly no. Now, if oil were to fall below $20, it would be a different story, but oil at $60 is down sharply only from a short-term speculative peak, not from "normal" oil prices in years past.

Shame on Professor Roubini for presenting such a weak argument. Okay, it was merely a "blog" post, but still, I expect an economics professor to think and express himself in a much more credible manner.

I would suggest that he investigate techniques for filtering out the effects of speculation so that we can look at how much of the price of a commodity is due to real demand and how much is due to speculation by parties other than the true end users.

-- Jack Krupansky


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