Top economist says the commodities bubble is fueled by low interest rates--not wet barrels shortage, the falling dollar, or "speculators."

Columbia economist Guillermo Calvo thinks the recent run-up in prices of crude oil and other commodities is caused by sovereign wealth funds fleeing cash and T-bills and rushing into commodities for higher returns. They are doing this, he says, because the Fed is keeping interest rates too low, and the result will be inflation. Paul Krugman, whose blog brought this to my attention, says he isn't persuaded, but that Calvo's explanation should be considered in a big debate that economists should be having to unravel the mystery. According to Krugman, "something awesome is happening to oil and other commodities, and figuring out what it means is crucial." I summarize their points and list all the factors I could think of that might be pushing up crude oil prices--because I'm pretty sure it isn't just one thing. 

Neither Calvo nor Krugman wants to blame "speculators" for the price rise. In Calvo's case that may be because he thinks the solution is for the Fed to start raising interest rates rather than to focus on operations in the commodities markets. But he does seem to agree with my basic point that the increased demand is for paper barrels, not wet barrels. Calvo seems to be saying that by raising interest rates the Fed can coax money out of commodities, but he doesn't seem to acknowledge the possibility that money might also flee commodities if a bear market were perceived. 

Krugman doesn't accept that there could be a price increase without a shortage of wet barrels--whether induced by hoarding or otherwise. I suggested here that there had been hoarding, but since then US crude oil inventories have been declining and are now only about 10% above minimum operational requirements. My summary of the speculation argument is here. The latter two posts have links to EIA and other data sources.

All of the following factors seem to have some influence on crude oil prices. By listing them all, I mean to exclude myself from all camps that argue for any single cause or explanation for crude oil price changes over the last year. The reason this is so hard to understand, I believe, is because there are multiple factors at work. 

Crude Oil Market Fundamentals

The fact (if it’s a fact) that available production capacity is just slightly more than demand and that the margin may shrink to zero in the next few months or years as demand grows rapidly in China and India. (So far there is zero evidence that there has been any physical shortage of wet barrels, but it is widely believed that a shortage is imminent, and beliefs about facts, not facts, make markets. The further belief is that if/when supply is maxed out, only price—and a pretty high price at that—will reduce demand to match available supply.)

The potential for supply disruptions caused by civil strife in Nigeria, hurricanes in the Gulf of Mexico, violence and lack of investment in Iraq, talk of war with Iran, etc., etc. (This is the so-called “risk premium.”)

The loss in value of the dollar versus other currencies—meaning that nominal oil prices have to rise if the same “real” selling price of crude oil is to be maintained.

Producing Nation Market Power

The ability of OPEC and especially the Saudis to administer prices within a broad range when, as now, all major producing nations are able to produce at or near capacity. (The Saudi oil minister said last week that any price above $70 is not justified by the supply/demand situation.)

The possible assessment by oil producing nations that the world can tolerate crude oil prices at or above $100 without “too much” demand destruction.

A possible shift in the thinking of producing nations, especially the Saudis, to favor slower rates of production in order to maximize oil revenues over a longer time period (even though the “net present value” of that strategy is probably lower, and even though the Saudis deny this speculation).

Possible changes in how producing nations, especially the Saudis, see oil prices and relative economic power in the region as affecting their geopolitical interests. (For example, in the Saudis’ view, is it better for Saudi Arabia to become even richer or for the current government of Iran to get into even more domestic political trouble as a result of declining oil revenues?)

The reduced geopolitical influence of the US. This would be due to the now obvious lack of US ability to impose its will on Middle East nations and to protect production and transportation of oil in the region, and due to a reduced sense of empathy and obligation toward the US.

Large Influxes of Capital into Commodities

A huge flood of capital into crude oil futures and options, as well as into commodities generally, both as a hedge against a decline in the value of the US dollar and as a bet on rising prices. When prices are rising investors want more, which further drives up prices.  Calvo describes this not as speculation but as seeking better returns than can be had in bank deposits and T-bills.