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Coping with ignorance

Created:
27 May 2008
Written by:
Chris Dillow

Some questions are important but unanswerable. The question of why oil prices are so high is one of them.

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It's important because the causes of moves in oil prices determines their impact upon the global economy. Between the 1970s and early 2000s, there was a close link (pdf) between oil prices and the US economy. Rising real oil prices led to rising unemployment, and falling prices to falling unemployment. But around 2002, this relationship broke down. Oil prices trebled between 2002 and 2007, but the economy grew nicely, pushing shares up.

This breakdown happened because the cause of oil-price rises changed. In the 70s, 80s, and 90s, big rises in oil prices happened because wars and revolutions cut supply. But in the 00s, oil prices rose because of demand from Asia. And this was the counterpart of a supply of cheap goods to the west and demand for western goods and assets. So interest rates here stayed low and demand high. Rising oil prices, then, were little problem for the economy or share prices.

The question is: how much is this changing? To what extent is the latest pick up in prices due to high demand (which is good for the economy and shares), or supply shocks (which are bad), or to speculative demand? It's easy to say a bit of each, but that's just unhelpful pompous judgment mentality. And insofar as speculative demand is driving prices up, what is this telling us? Are speculators rationally anticipating stronger demand, or supply disruptions, or are they merely jumping onto a bandwagon?

No one knows the precise, quantifiable, answers to these questions. Genuine experts acknowledge that oil-price moves are terribly hard to explain or predict. And the hard data are little help. These show (pdf), surprisingly, that world crude output has risen this year, after having fallen in 2006 and 07.

And this ignorance is an ineradicable fact. As Friedrich Hayek said, the key fact about markets is that knowledge is inherently partial and dispersed; the point of prices is that they efficiently aggregate this knowledge. If a single person could know precisely what the oil market's 'fundamentals' were, we could dispense with a market altogether and have a central planner set prices.

You might think all this is unhelpful - as if the truth must be useful. It's not. What I'm saying is that we should learn to live with oil-price volatility. In particular, don't expect any link between oil and general share prices to be at all stable. And don't trust those who say prices could rise even further. Of course they could. But there have always been strong reasons to buy at the peak of a bubble.

And look on the bright side. High petrol prices give you an excuse not to drive over to visit the mother-in-law.

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