Wednesday, December 30, 2015

What Do Falling Oil Prices Tell Us about the Dollar?

I recently blogged about my bearish positions on the oil and gold markets.  Today, the Wall Street Journal observes that oil prices are falling on the Saudi oil minister's statement that despite falling prices Saudi Arabia won't change its output.  Despite prices that are below most US producers' break even points, the US producers are covering their variable costs.  The journal writes:  "U.S. oil stockpiles remain near levels not seen for this time of the year in around 80 years."  Stockpiles' rising to record levels will further pressure ]oil prices.  In the short run the situation is bearish, but in the long run it is bullish.

What does this tell us about the dollar?  America's Keynesian and monetarist economists, Democrats and Republicans, have created a monetary system whereby the dollar serves as a reserve currency; governments, central banks, and citizens around the world hold dollars; and the dollar is backed by the full faith and credit of the government that fought the Iraqi War in order to eliminate weapons of mass destruction. The rationale for this system is that the sovereign dollar holders will act rationally.

Nevertheless, the sovereign producers of oil are also the sovereign holders of dollars.  As producers of oil, many are now producing at a loss.  If there can be a glut in the oil market, how can these sovereign producers assume the mantle of rationality when it comes to holding dollars?

The famous game theory model of the prisoner's dilemma predicts that when two parties do not share information the solution to the problem of choosing whether or not to collude tends to be suboptimal.  Of course, central banks speak to one another--much as European governments spoke to one another before a millennium of wars. 

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