An exchange rate is a ratio of two currencies whose movement primarily reflects changes in both countries that issue those currencies. In my international trade and international economies courses, I add that the current account can be approximated by the difference between national saving (private + government savings) – investment. If national saving exceeds investment, then there will be a surplus in the current account of the country whose exchange is of interest. If national saving falls blow investment, then there will be a deficit in the current account of that country.

In euro-zone, national saving exceeds investment, which means that the euro countries are experiencing a surplus in their current account as a whole. Obviously the protracted sovereign debt crisis has hurt investment in that area and contributed to the surplus in the current account. On the other hand, the injection of liquidity by the European Central Bank and later the use of quantitative easing have added to the weakness of the euro which has depreciated by 22 percent in the last year or so.

If we combine negative interest rates in the euro-zone, which mean financial institutions are chewing part of the savings, with the increasing savings in that area, the result is an atmosphere unsympathetic to keeping the euro money in the euro-zone thereby caused the exodus of the euro from the euro-zone. When a domestic currency crosses its country’s boundaries to other markets, it means an increase in the supply of that currency abroad, resulting in the depreciation of the flying currency as is the case of the euro and the euro-zone. The exchange rate I have in mind is the U.S. dollar price of the euro, which is defined as the U.S. dollar over the euro.

In the United States, the Federal Reserve is diverging from the other central banks. Foreign central banks are decreasing their short-term interest rate and pursuing easy monetary policy, while the Fed is getting ready to go the other way. On one hand, the European Central Bank, the People’s Bank of China, the Bank of Japan, the Bank of Korea and the Bank of Thailand, among others, have eased. On the other hand, the Fed has stopped its third QE last December and is now trying to shift gear to increase its short-term interest rate. Add the strengthening of the U.S. economy relative to the euro-zone’s economy and we get the 22 percent drop in the U.S. dollar/euro exchange rate, with the dollar getting stronger and the euro is getting weaker.

The decline in the world’s total foreign currency reserve is also emblematic of the strength of the dollar as the undisputed and dominant global currency. Total global foreign currency reserves dropped from $12.03 trillion to $11.60 trillion. With a drop in the supply of the U.S. dollars abroad, the dollar gains strength along with increases in U.S. short-term interest rates by damping the world’s demand for U.S. Treasury bonds. This bodes ill for the euro, which has benefited from central banks using part of the increases in their reserves to buy this currency.

The rapid appreciation of the dollar could be a problem for the Fed and the Obama administration. The Fed is groping the data to figure out what to do, and it does not seem to have clear thinking of what to do next. The strengthening of the dollar is deflationary and this does not help the Fed meet its 2 percent inflation mandate.

Moreover, we are having both a current account deficit and an appreciating currency, which usually do not go together. Finally, the Fed may be concerned with the contracting impact of the appreciating dollar on economic growth, carry trade and interest rate spreads at the time when it is considering making the first increase in short-term interest rates in more than seven years. The Obama administration is reaching out across the Atlantic and proposing the Transatlantic Trade and Investment Partnership agreement, which can be complicated by the rapidly strengthening dollar.

In major oil-exporting countries, there is an effective beg to the dollar, whether unilaterally or through heavy weighting in a currency basket. This means we should experience an appreciation of the riyal, dinar, and dirham, etc., which are the currencies of Saudi Arabia, Kuwait and Bahrain, and United Arab Emirates, among others. Moreover, since those countries do not have their independent monetary policy, we can also expect an increase in their domestic short-term interest rates. On top of that, the world demand for oil should go down with the appreciation of the U.S. dollar. The first loser in this case is the euro.

There is however a silver lining in the appreciation of the dollar. It should bring lower imports inflation to the oil exporters. But the United States is suffering from an inflation rate that is significantly below the target making it difficult for its monetary policy to harden.

The euro is going in the direction of having a parity with the dollar and is likely that one dollar will even buy more than one euro before the end of this summer. Concurrently, the oil price, which moves in the opposite direction to the dollar, should continue to head down towards $40 a barrel.

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There is more than one reason to store oil as producers turn out more oil than the world demands, which is the case now. Stored oil can be used in times of emergency, or to make a profit when prices go up. Oil can be stored in: underground salt caverns, over-ground storage facilities and oil tankers floating over the oceans.

The most popular storage facility is in Cushing, Oklahoma, due to two reasons. First, the West Texas Intermediate oil is priced in Cushing. Second, Cushing is connected with an impressive pipeline system that delivers oil to many refineries in the
United States.

These different storage depots have different costs. It costs 25 cents per barrel each month if oil is stored in salt caverns, while the cost is 50 cents to one dollar for oil stored above ground
in Cushing.

The most expensive storage form is storing oil in leased tankers over the oceans. This cost there is $1.25 per barrel each month. The storage will be cost effective and even profitable if oil prices move up significantly within months.

Greater oil in storage could move the oil price from contango to backwardation, which means the spot price will be lower than the futures prices, which is the case now. The extent of the fullness of these storage facilities means there is no place to store oil any more, and the newly extracted oil should go directly to the market sold at the
prevailing prices.

Additionally, since oil companies especially those that extract shale oil are burdened with debt, they must continue producing and sell all their oil on the market despite storage depot scarcity to pay off their debts.

Oil inventories in the United States are at an 80-year high, as oil storage is currently standing at 70 percent of full capacity, near 80 percent in Cushing and is expected to reach the maximum in April. Moreover, it is believed to be more than 90 percent in Europe, and 70 percent in China, Japan, Korea and South Africa.

Since the storage facilities are near full capacity, we should expect that in few weeks all oil produced should be sold on the market as production is continuing unabated This means spot oil prices should drop considerably in the coming weeks or months until new storage hubs are built.

The question now is: How much can oil prices drop?

My guess, it should try again to hug $40 a barrel or lower. According to the Wall Street Journal, the time the oil storage reached close to this level was 1998, when the oil price collapsed to $13.38 a barrel. If you factor in inflation since then, this price would be $19.18.

The base case scenario could be that oil would stay in storage for many months or few years with no new buyers in sight, which means the storage cost will mount and the speculators who stored the oil will panic, ending up dumping all stored oil on the market at the same time.

You could call this scenario a “run” on storage. Consequently, oil prices would collapse. Many small shale oil producers will
go bankrupt.

Major oil companies will however survive as more money will pour into their stocks. The “run on storage” scenario may also have implication for the current ban on crude oil exports.

Who will benefit from this fullness of oil storage? In addition to the consumers, oil refineries that are now undergoing maintenance will benefit big since cheaper oil means lower feed-stock costs.

Ladies and gentlemen, the oil price saga is not over yet. Do not listen to OPEC, people.

Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at op-ed@thetriangle.org.

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To the surprise of many, Japan has pushed itself into another bad recession in the last two quarters of this year. An economic recession is defined as a negative growth rate in two consecutive quarters.

This is exactly what happened to Japan when economic growth was negative 7.3 percent in the second quarter and was negative 1.6 percent in the third quarter, instead of an expected positive growth of 2 percent for the third quarter. This unpleasant surprise is hard to take, particularly after this country has undertaken aggressive quantitative easing since the end of 2012 and increased fiscal spending.
But in April 2014, the expansionist Japanese Prime Minster Shinzo Abe made a big mistake by increasing the sales tax from 5 percent to 8 percent; he also announced that he would levy another tax increase to make the rate go up to 10 percent. This fiscal austerity may not be recommended by any student who took Econ 202 (Principles of Macroeconomics) anywhere in the world.

Japan has been trying to emerge from a deflationary recession, but upon a few signs of economic recovery it could not wait to embark on this crippling austerity. A sales tax increase of this magnitude — and under the circumstances of prolonged recession and deflation — severely crimps consumer spending, which constitutes 60 percent of gross domestic product (close to 70 percent in the United States).

The United States made a similar mistake in 1936-1937 when President Franklin Roosevelt increased undistributed profits tax and also made spending cuts, causing the economy to go back to recession after the grave years spent going through the Great Depression that began in 1929.

By the spring of 1937, U.S. wages, production and profits had regained their 1929 level but unemployment remained elevated — although lower than the 25 percent that prevailed in 1929. Unemployment jumped from 14.3 percent in 1937 to 19.0 percent in 1938 and industrial production plunged by 30 percent. This recession lasted for 13 months.
We can understand Japan’s concerns about its very high debt-to-GDP ratio, which comes to about 200 percent. This is the highest percentage in the 34-member-country Organisation for Economic Co-operation and Development. But this woe is not a pressing short-term problem and it can wait, as they say in the AT&T advertisement.

There was no exigent reason to raise the tax rate by 3 percent in April and announce a planned increase by 2 more percentage points in 2015. Most of Japan’s debt is in yen and not in a foreign currency.

On the other hand, Greece, which has had a terrible fiscal crisis, has its debt in euro, which is not its domestic currency. Japan can monetize its domestic debt by printing yen; Greece cannot. Moreover, what Japan really needs now is a demand boost more than supply side reforms because it does not have high unemployment and high inflation to prefer the supply side.
Japan’s new recession also came at the wrong time for the United States and the rest of the world. It should directly and negatively impact American exports to Japan. The world’s third-largest economy was the fourth-largest trading partner for the U.S. last year after Canada, Mexico and China.

Japan’s recession would appreciate the value of the U.S. dollar, which means lower American prices at home at a time when the U.S. is feared to be slipping into deflation. It may affect Japan’s quantitative easing and its positive impact on the U.S. stock market. Japan is also a large buyer of U.S. Treasury securities.

It owns more than one trillion dollars of those securities. It buys them because of their low default risk and also to keep its yen more competitive with respect to the U.S. dollar and other currencies. The objective is to increase Japanese exports. A prolonged recession in Japan can thus affect U.S. interest rates and appreciate the dollar further. The Japanese recession will also affect Japan’s exports to other countries in East Asia, particularly China.

This important episode tells us that policymakers at the highest level should have some minimum competence in economics and they should also have competent economic advisers. Economic mistakes are devastating mistakes.

Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at op-ed@thetriangle.org.

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OPEC will have its incoming meeting Nov. 27. This is a considerably important meeting for oil prices, global economic growth and all motorists in the world. OPEC has said that it will not cut its production and will let oil prices, which have already plunged by more than 25 percent this year, decline.

Will OPEC cut its production in order to stabilize oil prices? In other words, are the Saudis bluffing about being comfortable with current oil production and are they actually not happy with the market doing the pricing?

To answer this question, we can look at OPEC’s current production and its production history. And since OPEC is really Saudi Arabia, we can bring up the subject of whether the Saudis are tactical or strategic decision makers.

OPEC’s current production for this month has dropped by 220,000 barrels a day. While this is a symbolic cut because OPEC needs to cut production between one to one-and-a-half million barrels a day out of it current production of more than 30 million barrels a day to stabilize prices, it goes against what it has been saying that it will not cut production in its scheduled meeting.

It will be interesting to know who has been doing the current cut. Specifically, it will be very interesting to discern if Saudi Arabia is doing the cut.

Historically and sporadically, OPEC and Saudi Arabia followed policies that let the market determine oil prices. In 1985, the Saudis moved from being the first-mover swing producer that cut production to prop up oil prices to letting the market do it through introducing the net back pricing formula.

Shortly, oil prices collapsed from $40 a barrel to $10. The Saudis realized that the oil market had unusual dynamics and the market cannot be trusted in determining the oil price. In 1999, OPEC did not cut production in the wake of the 1997 Asian financial crisis and then oil prices also collapsed to $10 a barrel.

OPEC retreated and cut production in 2000 through introducing the target zone pricing. The OPEC oil price then jumped to $25 a barrel. Therefore, it will be interesting to develop an economic theory on the dynamics of the oil downward spiral. It seems that oil prices can drastically drop within a short period of time if the circumstances are not favorable.

Applying this narrative to the current circumstance, oil prices can plunge to $50 a barrel if OPEC does not act, a price that can harm almost all OPEC members — including Saudi Arabia, which has an inflated government budget to chase the Arab Spring away from its borders.

Recent history tells us that the oil price has a floor of $30 a barrel. This price floor prevailed during the horrible period of the Great Recession. But the world is not in a global recession; thus, $50 may be the worst case scenario for the current period if OPEC does not act.

Reading the oil and political policies of Saudi Arabia, one can infer that its decision makers are more tactical than strategic. This means they are more interested in the short-run than the long- run.

Their tactical policy can be detected from their strategies in Yemen and Egypt a well as from their oil decision-making. It can also be inferred from their policy with the Islamic State group and the domestic war in Syria. This is not surprising because the country is highly oil-based and does not have an elected government.

Back to OPEC, the member states will have a difficult meeting and will stack up Iran and Venezuela against Saudi Arabia and its allies. If there is no agreement and the oil price collapses below $70 a barrel, it will increase the tension in the Middle East particularly between Iran and Saudi Arabia and will also increase the worries of Saudi Arabia about meeting its fiscal obligations despite its $450 billion in international reserves.

Based on that and the record of Saudi decision-making, OPEC is likely to converge into cutting oil production between 500,000 to one million barrels a day. The oil markets has somehow sensed that and increased prices Nov. 14. Tactics overwhelm strategies for Saudi Arabia.

Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at op-ed@thetriangle.org.

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Oil prices collapsed in 1985 after the Saudis could not continue to perform the role of swing producer, which considerably squeezed their oil productions and revenues during those years. They let things go for a while and adopted the net back pricing which within a short period caused the oil price to plunge to $10 a barrel.

In 1997, the Southeast Asian economies suffered a severe currency crisis which led to a difficult recession in those countries. Oil prices collapsed again in 1999.

Now in 2014, the European countries are on the brink of a third recession and Japan’s weak growth seems to be stuck in its place. China is also showing slow growth. In addition, there is an oil glut in the world. In the fall season there is usually a depletion in oil inventories, but this fall oil inventories are going counter-cyclically which means they are rising.

More importantly, it does not seem that OPEC was keeping abreast of what has been happening in the oil shale market over the last four years and now it is caught with its pants down. In addition to the rapid increases in oil production in the United States and that the Saudis and the Kuwaitis are now after maintaining their market shares, there is a new element on the pipeline front.

The opening of the East Siberia-Pacific Ocean pipeline from Russia to China (3,018 miles) is enabling the former country to compete with Saudi Arabia with better quality oil at a lower price. In return, by cutting its price to Asia, which usually carries a premium over the prices it charges Europe and America, Saudi Arabia hopes to directly undercut the Russian competition.

Consequently, it seems that OPEC is in disarray. This is the perfect storm for a fast plunge in oil prices that may even surprise the Saudis.

I wonder if the Saudis have a concrete oil plan in conducting their market share strategy going ahead. If one of the objectives is to slow the oil shale production in the United States like the one in the Bakken fields in North Dakota and the Marcellus fields in Pennsylvania, they have to put up with prices as low as $60 a barrel or even lower.

The Saudis have a breakeven oil budget price of about $90 a barrel. They could survive this constraint for a year or so at a price of $60 or less. But in the midst of the political turmoil in the Middle East and given the Saudi bloated government budget, can the Saudis survive a $60 a barrel for more than a year?

Shale production started in the 2008-2009 period when the United States was going through the Great Recession and the West Texas Intermediate price dropped to $30 a barrel.

There also are those on Wall Street who believe that shale production in certain areas of the United Sates can survive $28 a barrel. Can the Saudis survive that?

Moreover, the shale revolution is bringing technological advances in shale drilling, which means that shale oil prices should drop for several years before they stabilize like the prices of solar energy.

If the other objective is to hurt Iran and Russia, this will bring the Saudis more costs than benefits. The Iranians have already absorbed the U.S. sanctions and their economy has started to grow. Now they want to compete with the Saudis head-to-head in terms of increasing oil production.

If Russia is hurt, putting politics aside the hurt will transcend to international banks and European economies, which turn may affect the U.S. economy and global growth. The economic growth cycle will not end until it drops oil prices further. Standing now at $80 a barrel, some guess the next level is $70 while others go as low as $50.

What OPEC and the Saudis should do is to learn from their experiences in 1985-86 and 1998-99.

In those years the Saudis got the cooperation from their colleagues in OPEC to cut production. In 1998-1999, they received cooperation from Norway, Mexico and Russia who they are trying to hurt now. The Saudis are playing the wrong political game.

Since they stopped using oil as a political weapon, they should stop playing this game. They should learn from their successes in 1986 and 1999, rally oil-exporting countries inside and outside OPEC to stop the prices from an eventual drastic plunge. The Saudis should also stop their politics and live within their means.

Meanwhile, I and many consumers are now happy when we go to the gas station!

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.

In my previous article, “Oil prices on surprising decline,” published Oct. 10, I indicated that in order to understand the signals coming to us from a major economic variable, it is important to read the signs coming from the variables associated with it.

For example, to figure out the changes in short-term interest rates, it is useful to read the changes in long-term interest rates, the rate of future economic growth, and the inflation rate. In return, understanding the direction of interest rates may have a predictive power for future economic growth, exchange rate and inflation

Currently, some short-term rates in the United States are traded at negative yields. Moreover, the two-year interest rates are yielding negative returns in Belgium, Denmark, Finland and Netherlands. Negative interest rates are something unheard of before the 2008 financial crisis.

This means that investors are seeking safety in the short-run and seeing trouble in the economy ahead. Thus, the safest way to follow now is to buy Treasury bills, which last less than one year.

If we assess the signals coming from long-term interest rates, we can presume that those rates are hesitant to move up, thereby indicating that investors are uncertain about economic growth in the long run. Putting the short and long run data together in a curve shows that the yield curve is not steepening but rather may be flattening.

Macroeconomics tells us that flattening yield curves imply slow or declining economic growth in the near future, with the possibility that the economy may dip into recession. Reading the current anecdotal data of the state of the U.S. economy, it shows that this economy contracted by 2.1 percent in the first quarter but grew at 4.6 percent in the second quarter of 2014. Looking at the first half of this year, economic growth was 0.9 percent. A similar thing happened in 2011 after which the economy went on a roller coaster ride.

What is the implication of a flattening yield curve? It implies that there is high uncertainty about the future pace of the economy and that any monetary tightening by the Federal Reserve now is likely to slow economic growth further and may push the inflation rate lower into a dangerous zone, which could lead to deflation.

It also implies that the growth in wages will remain modest for the near future, suggesting that the consumer will continue to limp along.

The anecdotal facts also show that there is still a considerable slack of labor in the economy, despite the recent drop in the unemployment rate. There is not a noticeable rise in the wage rate, so there is no threat of cost push inflation. There is no fear of inflation rising greater than 2 percent any time soon.

Economic growth is also not accelerating. Internationally, the world’s second largest economy is slowing down and the eurozone is teetering into a new recession. The Russia-Ukraine crisis and the sanctions will also weaken economic growth in Europe and the United States.

This confluence of major global factors points to a high probability that short-term interest rates will decline after the Federal Reserve is done with its bond purchasing next month. Why is the stock market getting so jittery? Why does the dollar keep rising?

Markets do get irrationally nervous as people do. Interest rates and the exchange rate are spooking the markets.

We should be aware that the Federal Reserve does make mistakes of great proportion that can plunge the world’s largest economy into recessions. History has shown that the Federal Reserve tightened prematurely in 1937 after the economy became robust, sending the economy back into recession after struggling for several years to emerge from the 1929 Great Depression.

Given the current anecdotal facts about the U.S. economy, we can say now that it is premature for the Federal Reserve to tighten. The yield curve says: “Don’t tighten any time soon because the economy may go on another roller coaster ride which should end in a new recession.”

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.