The Secret History of Oil and Money - Part 6

For this chapter, I will use the excellent book, The End of Oil by Paul Roberts as a guide.

Last time we saw how oil prices crashed in the 1980's setting up the emergence of Neoliberalism as the predominant theory governing the planet's economy. Oil prices played a role in the collapse of the Soviet Union, the Latin American debt crisis, and the rise of Islamic Fundamentalism in the Middle East.

 Starting in the mid-1970s the Islamic resurgence was funded by an abundance of money from Saudi Arabian oil exports. The tens of billions of dollars in "petro-Islam" largess obtained from the recently heightened price of oil funded an estimated "90% of the expenses of the entire faith."

Throughout the Sunni Muslim world, religious institutions for people both young and old, from children's maddrassas to high-level scholarships received Saudi funding, "books, scholarships, fellowships, and mosques" (for example, "more than 1500 mosques were built and paid for with money obtained from public Saudi funds over the last 50 years"), along with training in the Kingdom for the preachers and teachers who went on to teach and work at these universities, schools, mosques, etc. The funding was also used to reward journalists and academics who followed the Saudis' strict interpretation of Islam; and satellite campuses were built around Egypt for Al Azhar, the world's oldest and most influential Islamic university.

The interpretation of Islam promoted by this funding was the strict, conservative Saudi-based Wahhabism or Salafism. In its harshest form it preached that Muslims should not only "always oppose" infidels "in every way," but "hate them for their religion ... for Allah's sake," that democracy "is responsible for all the horrible wars of the 20th century," that Shia and other non-Wahhabi Muslims were "infidels", etc. While this effort has by no means converted all, or even most, Muslims to the Wahhabist interpretation of Islam, it has done much to overwhelm more moderate local interpretations, and has set the Saudi-interpretation of Islam as the "gold standard" of religion in Muslims' minds.

State-sponsored terrorism (Wikipedia)

The arrival of the OPEC cartel and the boycotts and revolutions caused oil prices to rise tenfold during the decade of the 1970's. Control over the world's oil supplies now resided with the governments of a handful of countries rather than the oil companies (who nevertheless also benefited from higher oil prices). This created the greatest transfer of wealth in the history of the modern world.
The countries who were the beneficiaries of this windfall changed dramatically, from desert backwaters with small populations to wealthy nations enmeshed in global geopolitics.

Take Sheikh Rashid of Dubai. Dubai is one of what the British called the Trucial States when, in the nineteenth century, they established a military presence in this lightly populated area of desert and salt marshes on the Persian Gulf. Sheikh Rashid, before the oil, had derived his income from the dhows, the wooden sailing ships that called at his customs house, on the way to "reexport"—some said smuggle—gold and silver to India, before the oil—the first strike was not until 1957—Sheikh Rashid feuded with Deira, the rival village across the creek. The weapons used in this feud were the cannons from old ships, some of them hundreds of years old. The cannons were stuffed with rags and pistons from hijacked cars, and since cannonballs were in short supply, a nightly truce after sunset prayers permitted the combatants to comb the battlefields and retrieve the cannon balls.

One day, in the pre-oil era. Sheikh Rashid accepted a dinner invitation across the creek, and then had his men kill off his hosts. In the best Middle Eastern tradition— and not unlike Richard III—he consolidated his victory by marrying the thirteen-year-old daughter of the vanquished ruler of Deira to his brother. The Sheikha Sana, as she is called, is a high-spirited woman who once shot her husband's fourth wife. She says, of her early years, that her experiences made her strong, and she has now built up a thriving taxi fleet. Sheikh Rashid married his daughter, Miriam, to the neighboring Sheikh of Qatar, who lent him the money for a bridge across the creek.

Sheikh Rashid's income is now about $1 billion a year, and no one hunts for cannonballs anymore in Dubai. His in-law, the Sheikh of Qatar, produces more oil and is even richer. In the nineteenth century the British navy sailed the Persian Gulf to protect the routes to India; now their former Persian Gulf wards come to London. Sheikh Rashid's ambassador, Mohammed Mahdi al-Tajir, drove the British press to xenophobic frenzy by purchasing $60 million in English real estate in two years: town houses, country houses, and the centuries-old castles of dukes. "Arabs like beautiful things," he said simply. The British press shuddered deliciously at the new, Mephistophelian image of its visitors. The Daily Mirror warned of "school    girls missing after dating Arabs," whisked off to "exclusive restaurants in Rolls Royces."

Paper Money; pp. 187-188

Oil prices are a funny thing. Too high and you slow down the economies you need to sell to, driving demand down. Killing the goose, as it were. If they are low, by contrast, your buyers will use plenty of oil driving around in their SUV's, but you will not make enough revenues. Your budgets will collapse. High oil prices hurt oil-importing nations but help oil-exporting nations. Low oil prices help oil-importing nations, but hurt oil-exporting nations. You need a Goldilocks price.

In the 1970'sThe OPEC nations got greedy. The high prices made them rich beyond imagination, while bringing the industrialized nations to their knees. But the thing is, high prices have effects.

1.) When they get high, the demand for oil goes down. People don't drive as much. They don't take a vacation. Construction slows down. Businesses refuse to expand.  If people pay more for the gas they absolutely need, they spend less on other things. There is less economic activity overall. This means there is less demand because the economy is shrinking. Even if supply remains constant, decreased demand will lower prices.

2.) Efficiency measures that do not make sense with cheap oil make sense with expensive oil. People buy more efficient cars. Automakers raise the energy efficiency of their designs. People insulate their homes and turn down the thermostats. Tankers move slower to save oil. Businesses seek more efficient ways to do things, and engineers get to work on using energy more efficiently.

3.) Higher prices make alternatives economically viable. This could be renewables like solar and wind. It could mean small-scale ethanol and biodiesel. It can also mean things like electric cars. But it can also mean other fossil fuels like coal and natural gas:

Until the early 1950s, natural gas sold for less than three cents per thousand cubic feet. Drillers looking for oil learned to avoid areas that had been, or were today, deeper than the oil window. Today, natural gas sells for more than $3 per thousand cubic feet. Increasing the price by a factor of one hundred is a morale builder. Suddenly, all those natural-gas-only terrains were profitable targets. The "oil boom" of the early 1980s was actually a gas boom. Kenneth Deffeyes, When Oil Peaked; pp. 98-99

4.) Higher prices call forth additional production as it becomes more profitable to search for oil elsewhere. This is what happened back in the 1980's. As oil prices went high, it created an incentive to scour the world in non-OPEC countries seeking out new oil fields. Fields that previously would have been too expensive to develop suddenly become viable; the North Sea and Alaska for example. It becomes economically viable to build pipelines to move oil from distant fields that were too distant to develop before.

5.) Higher prices cause you to lose market share. Sell your oil for too much money, and if someone can sell it cheaper they will do so, decreasing your share of the market. Since OPEC was a price-setting cartel, any seller outside of OPEC was free to undercut not only them, but each other.

As OPEC loses market share, so will its individual members. This may cause individual members to want to defect, sewing discord among members and setting off price squabbles. They will try and hide this from other members by doing things like lying about their true reserves, cheating on their production quotas, etc.

All of these factors combined to create the oil glut.

But OPEC's biggest weakness was its profound misapprehension of the mechanics of oil power, particularly the setting of prices. As the owner of the world's cheapest oil, OPEC could easily have used its lower production costs to outsell its rivals, like Russia or Mexico — countries that needed to charge more per barrel to make a profit. Such a low-cost strategy would have let OPE C gain a majority share of the world oil market, while still earning a reasonable price for its oil. To succeed at such a strategy, how ever, OPEC couldn't get too greedy. If cartel members tried to push prices too far up by withholding their own production (and thus tightening world supply), the effects would be disastrous. Importing nations would either turn to non-OPEC suppliers (thus reducing OPEC's precious market share), or they would simply use less oil, either by switching to cheaper fuels, like coal or gas, or by becoming more energy-efficient.

So when oil prices skyrocketed during the 1970s and early 1980s, OPEC would have been wise to pump a little more oil and let prices fall slightly. That way, the cartel would have ensured a long-term market tor oil by reassuring the big consumers, like the United States, Europe, and Japan, that oil was a reliable, economical, long-term energy source. True, OPEC's revenues would have fallen off a bit; but by protecting its market share and its customers, the cartel could have made up any losses later, when prices recovered, as they inevitably would have. 

Instead, OPEC did the opposite. Addicted to the higher oil revenues of the 1970s, OPEC members refused to reduce their prices. The high prices acted as a brake on global economies accustomed to cheap energy, and the entirely predictable result was widespread recession. Energy demand fell, and importing nations tried to "wean themselves from "foreign oil. Utilities and other industrial users switched to coal, natural gas, and nuclear power, which were now cheaper. Homeowners began heating with natural gas instead of furnace oil. Governments in the United States, Japan, and Europe, embarking on a crusade for energy conservation, poured billions of dollars into alternative fuels and technologies and forced automakers to build fuel-efficient vehicles. For the first time in nearly a century, oil was losing its allure as the miracle energy source, and the impact was staggering. By 1986, world oil demand had fallen by five million barrels a day.

Worse, just as oil demand was falling, a wave of new oil production hit the market. Norway, the United Kingdom, the United States, the Soviet Union, and other non-OPEG countries, whose oil was normally too expensive to compete with OPEC's, now scrambled to take advantage or the high oil prices. Between 1978 and 1986, non-OPEC oil production jumped by fourteen million barrels a day — and most of this increase came at OPEC's expense. Between falling demand for its own oil and rising non-OPEC production, OPEC saw its share of a dwindling market shrink from more than 50 percent to just 29 percent. In retrospect, says one former U.S. State Department official, it is clear that "OPEC [members] had no idea what they were doing. It was totally unrealistic of them to think they could keep prices that high for as long as they did and not have a huge impact on demand."

Desperate to avoid further damage, Saudi Arabia, OPEC's most powerful member, tried enforcing a production limit, or quota, on each member, to reduce supply and shore up prices. But other OPEC members refused. While most saw that cutting production could bring higher prices eventually, in the short term, it would mean an immediate loss of oil income — something no formerly free-spending petrostate could withstand. In Nigeria, desperate oil officials actually cut their prices in an attempt to boost sales and grab back some market share from non-OPEC countries. Mexico, too, lowered its prices.

The Saudis now found themselves in the classic cartel bind: the only way to keep prices high was to cut their own production, as they reluctantly did, letting it fall from lo million barrels a day in 1980 to a mere 2.5 million by 1985. However, this remedy too proved disastrous. Although prices did rise, the Saudi market share was now so tiny that its overall oil revenues remained dangerously low. As the situation worsened, the Saudi royal family felt it had little choice but to turn the "oil weapon" on OPEC itself. Opening its taps, the Saudis flooded the world market with cheap oil.

This first use of "capacity cleansing" was brutal but effective. As price plunged below ten dollars a barrel, Venezuela and other OPEC quota-busters capitulated and cut their production. Saudi Arabia regained its lost market share. Better still, from OPEC's point of view, rival oil operations in high-cost areas like the North Sea and Alaska suddenly became uneconomical, and many were scaled back or even put on hold. These developments hit the Soviet Union, until then the world's largest producer of oil, particularly hard. As falling oil prices cut Moscow's hard-currency income in half, the Soviet oil industry — and the Saudis' biggest oil rival — was knocked out for years.

The End of Oil, pp. 102-103

Now it's important to know that Saudi Arabia's oil is ultra-cheap to produce. Their massive oil fields are under high pressure against the surface rock formation. The oil comes out via wells and does not need to be pumped. Just stick a straw in, as it were. Compare that to the massive offshore oil rigs in the North Sea, for example. Plus, Saudi oil is light crude which is very easy to refine. Only Iraq's oil is cheaper to produce.

Because Saudi oil was so cheap, they could produce it for a price that would drive other countries out of the business. The would "open the spigot" and send oil prices crashing. This would cause expensive oil to no longer be viable and drive other, higher-cost producers out of the market. Saudi Arabia even does this with their own cartel members to enforce discipline. Step out of line and the Saudis will send the prices down screwing up your budgets. It's called "capacity cleansing."

The other thing "opening the spigot" means is that Saudi Arabia can quickly add oil to the market to smooth over price swings. Demand goes up, price gets a bit high, and the Saudis will turn the tap. If it gets too low, they will close the tap.

All these factors are important to understand what is going on today. We will return to them shortly.

In 1989, Iraq's dictator Saddam Hussein had just concluded a costly war with Iran. He needed a high price for his oil to rebuild Iraq. His neighbors, however, did not want Saddam, with his huge military and imperial ambitions, to get more money.

In 1989, having just finished a long and costly war with Iran, Saddam was desperate to sell as much of his oil as he could to replenish his depleted treasury. His neighbors, however, had no interest in seeing Saddam get any richer or stronger. Kuwait in particular feared Saddam and, in an effort to deprive the Iraqi leader of oil revenues, stepped up its own production, intentionally flooding the market and as a result depressing prices. Saddam was not amused. He regarded the Kuwaitis' tactics as tantamount to economic war — he could claim that Kuwait was "stealing" Iraqi oil revenues — and made it clear he would take military action. Too late, the Saudis saw the danger: if Saddam invaded Kuwait, he would probably press on into Saudi Arabia. Desperate to placate the well-armed Iraqi dictator, the Saudis cut their own production and begged Kuwait and other OPEC states to do the same, to push prices back up to twenty-one dollars — high enough, it was hoped, to mollify Saddam and dissuade him from attacking anyone. 

The tactic might have worked. Now, however, Venezuela refused to play along. Still reeling from the price collapse of the 1980s — and never terribly interested in Middle Eastern politics — the Venezuelans opened the taps. That move, coupled with similar cheating by United Arab Emirates, effectively destroyed any hope of price appeasement. By 1990, Saddam had massed troops on the Kuwaiti border and, believing the United States to be unwilling to risk a war just for oil, launched his invasion. 

The End of Oil, p. 105

The Gulf War caused a spike in oil prices. As one would expect, the U.S. went into a short but painful recession. The conservative governments which had ruled since 1980 were finally toppled. Reagan's vice president, George Herbert Walker Bush, was defeated by Democrat Bill Clinton who campaigned on "It's the economy, stupid!" Tony Blair's labor party took over from John Major, Thatcher's successor. However, Clinton was a "third way" politician combining Neoliberal economic policies with slightly more worker friendly attitude and more progressive social policies. In essence, both parties had adopted the Neoliberal economic paradigm. Clinton ran on reducing welfare and making government more efficient. He declared, "The era of big government is over." He repealed the Glass-Steagall act which had been put in place during the Great Depression to regulate the excesses of the banking industry.

The 1970's oil shock and the 1980's oil glut taught a valuable lesson. Rather than mutually assured destruction, stability became the overriding goal. It was the swings in cost, even more than cost per se which screwed up the world economy. Price swings hurt both producers and consumers. A Goldilocks price which would allow for both interests is what was required. Thus a new alliance was formed. The Saudis would arrange price stability as the "swing producer," with the Americans providing the military protection as the preeminent power in the Middle East. The post-Gulf War Era was a golden era of price stability. The economy performed even better than in the 1980's (which people tend to forget). Jobs were plentiful. The internet economy started up (and formed a bubble). Clinton built his "bridge to the 21 century" on low and stable oil prices.

Concerns grew over the stability of the Middle East, however. The Islamic fundamentalism that the Saudis funded and encouraged threatened to destabilize the region. Despite the price stability, America was still an oil importer whose production had peaked in 1970. Saudi Arabia, with it's ailing king and corrupt family of princes, seemed perpetually at risk of implosion from within. Other oil producing nations like Venezuela under Hugo Chavez were openly hostile the the U.S. (prompting a U.S. backed coup attempt in 2006).

In 2000 the Supreme Court appointed George H.W. Bush's son, George W. Bush as president. Bush and his vice president were former oil men, as were many of his advisers and cabinet members. It was as if the oil industry had taken over the government. Islamic terrorism was about take a big bite, however, with the September 11 attacks. Although the attacks were carried out by 15 Saudi Nationals and 4 Egyptians, the Bush administration used it as an excuse to attack Saddam Hussein's Iraq through a campaign of innuendo, misinformation, and outright lies. The invasion, in violation of the UN charter against preemptive war, began on March 20, 2003.

The concept behind the invasion of Iraq is often misunderstood. The real purpose was less to control oil, and more about breaking OPEC. The Neocons believed that the fall of the Soviet Union meant that the only real threat to American hegemony came from Islamic terrorism and OPEC's control over the "oil weapon." Iraq's oil, as we mentioned, is even easier to get at then Saudi Arabia's. There was also a lot of it due to Saddam's mismanagement. If American oil companies could control the Iraqi oil, they could stabilize oil prices without Saudi Arabia's help. They would have their own "spigot" as it were, under America's control. When America took Iraq, the first thing they did was protect the oil wells. In Baghdad, the first building to be secured was the oil ministry. Despite the disruption, Saudi Arabia's "swing" capacity was remarkably able to keep oil prices stable throughout the war.

As far back as 1975, as the Arab oil embargo slowly strangled American economic might, conservative economists and policymakers were searching for ways to defeat OPEC. Although the Nixon administration's plans to take OPEC's Middle Eastern oil fields physically were shelved, the dream of a post-OPEC oil order was kept alive by a cadre of neoconservative American analysts and policymakers — among them, Paul Wolfowitz, now deputy defense secretary, Richard Perle, a top adviser to Defense Secretary Donald Rumsfeld, and, of course, Rumsfeld himself.

In the 1980s, the neocons had supported sanctions against oil sales from Libya and Iran, in hopes of depleting their terrorist budgets — a move that earned them the scorn of big oil companies. A few years later, some neocons began arguing that even Saudi Arabia, that stalwart oil ally, was looking less and less loyal: not only were members of the Saudi royal family reported to have spent five hundred million dollars to export radical Islam, but Riyadh was the ringleader of a pricing regime that was hurting American interests. "For a lot of conservatives, the Middle East, or a significant part of the Middle East, has effectively been at war with the United States ever since the 1970s," says a policy analyst with close ties to the Bush administration. September 11 "was just one final argument that these elements need to be taken care of."

And the key to "taking care" of those elements was Iraq, a country that had at least 150 billion barrels of crude and, except for Saudi Arabia, the cheapest production costs in the world.' Months before the September 11 attacks, when Vice President Cheney (another former oilman) was drawing up a new national energy policy, he and other White House energy strategists had pored over maps of Iraqi oil fields to estimate how much Iraqi oil might be dumped quickly on the market. Before the war, Iraq had been producing 3.5 million barrels a day, and many in the industry and the administration believed that the volume could easily be increased to seven million by 2010. If so — and if Iraq could be convinced to ignore its OPEC quota and start producing at maximum capacity — the flood of new oil would effectively end OPEC's ability to control prices. As supply expanded, prices would fall dramatically, and not even the Saudis with their crying revenue needs would be able to cut production deeply enough to stop the     slide. Caught between falling revenues and escalating debts, the Saudis, too, would be forced to open their oil fields to Western oil companies, as would other OPEC countries. The oil markets, free at last from decades of manipulation, would seek a more natural level, which, according to some analysts, would be around fourteen dollars a barrel, or even lower — a price much more conducive to long-term economic growth.

Toppling OPEC wouldn't be easy. Reviving Iraq's moribund oil industry would take massive infusions of capital. By some estimates, it will cost five billion dollars just to resume prewar production levels, and at least forty billion over the long haul. That kind of money could come from only one source — the international oil companies — which would invest in Iraq only if a) Saddam were gone and b) they received some assurance that they would have a share in production revenues and that the market, and not OPEC, would determine production levels.

It is a radical vision. At a stroke, the administration hopes to depoliticize what has for nearly a century been the quintessential political commodity and, in the process, remove the last real obstacle to American power. As Michael Klare, professor of world security studies at Hampshire College, told the Toronto Star last year, in the eyes of the Bush administration, unlocking OPEC oil, "combined with being a decade ahead of everybody else in military technology, will guarantee American supremacy for the next fifty to one hundred years."' Cheney and Rumsfeld "see control of oil as merely part of a much bigger geostrategic vision," argues Chris Toensing, an analyst who works on the Middle East Research and Information Project. "By controlling the Gulf and the Middle East, the United States gains leverage over countries that are more dependent on the Gulf for oil, like China and Europe."

The End of Oil, pp. 111-112

The stable oil prices meant that inflation was low or nonexistent. This led to very low interest rates throughout the 1990's and 2000's. Clinton had deregulated wall street. Currencies floated against each other was we saw. The economy had been globalized thanks to the cheap costs of shipping due to improved tankers and cheap oil. All of this caused a massive housing bubble to inflate. As long as housing prices were increasing faster than interest rates, it mad sense to borrow to a buy house and "flip" it to another buyer. Owners could also refinance their homes to come up with extra cash, using their homes as an ATM machine thanks to inflated property values. Corruption reigned in both Washington and Wall Street, but people were doing well, so they looked the other way. Alan Greenspan, a Neoliberal Ayn Rand acolyte and advocate of rational, self-regulating markets, presided over the Federal Reserve.

Post Gulf War 2, things seemed to be going well. The stock market was riding high. House prices were rising. Banks were flush with money. Growth rates were good and "official" unemployment was low. The American worker however, thanks to Neliberalism, has not seen an increase in real wages since 1973.

In the late 1990's and early 2000's a group of retired engineers started to echo M. King Hubbert's warnings from the 1950's. They formed groups like ASPO and argued that the globe as a whole was approaching Peak Oil. The slowdowns of the 1970's had postponed the day of reckoning, but the three decades of cheap oil had led to the abandonment of any alternatives. No new major oil fields had been discovered, and the world was running on supergiant oil fields that had been discovered in the 1940's-1960s which would inevitably decline. Since oil was a global commodity in which exports and imports had to balance, the exporting nations could not make up for countries in decline.

In 2008, gasoline prices spiked, with price almost trebling in eighteen months. In July 2008, oil skyrocketed to $147 a barrel, more than doubling the price of crude over the 12 months to that time. Many thought oil would race past the $150 mark on the way to $200 and to $300 a barrel. This set a new record high in both absolute and inflation-adjusted terms. The economy went into freefall. "This sucker could go down," was George W. Bush's sage pronouncement. Thanks to the fiat money we talked about in part 3, billions of dollars were conjured out of thin air by "keystrokes" to keep the banking industry solvent.

The three developments noted above – growing inequality, a speculative financial sector, and a series of large asset bubbles – account for the long, if not very vigorous, economic expansions in the US economy during 1982-90, 1991-2000, and 2001-07. The rising profits spurred economic expansion while the risk-seeking financial institutions found ways to lend money to hard-pressed families whose wages were stagnating or falling. The resulting debt-fueled consumer spending made long expansions possible despite declining wages and slow growth of government spending. The big asset bubbles provided the collateral enabling families to borrow to pay their bills.

However, this process brought trends that were unsustainable in the long-run. The debt of households doubled relative to household income from 1980 to 2007. Financial institutions, finding limitless profit opportunities in the wild financial markets of the period, borrowed heavily to pursue those opportunities. As a result, financial sector debt increased from 21% of GDP in 1980 to 117% of GDP in 2007. At the same time, financial institutions’ holdings of the new high-risk securities grew rapidly. In addition, excess productive capacity in the industrial sector gradually crept upward over the period from 1979 to 2007, as consumer demand increasingly lagged behind the full-capacity output level.

The above trends were sustainable only as long as a big asset bubble continued to inflate. However, every asset bubble eventually must burst. When the biggest one – the real estate bubble – started to deflate in 2007, the crash followed. As households lost the ability to borrow against their no longer inflating home values, consumer spending dropped at the beginning 2008, driving the economy into recession. Falling consumer demand meant more excess productive capacity, leading business to reduce its investment in plant and equipment. The deflating housing bubble also worsened investor expectations, further depressing investment. Finally, in the fall of 2008 the plummeting market value of the new financial securities, which had been dependent on real estate prices, suddenly drove the highly leveraged major commercial banks and investment banks into insolvency, bringing a financial meltdown.

Thus, the big financial and broader economic crisis that began in 2008 can be explained based on the way neoliberal capitalism has worked. The very same mechanisms produced by neoliberal capitalism that brought 25 years of long expansions were bound to eventually give rise to a big bang crisis.

Understanding Contemporary Capitalism, Part 1 (Triple Crisis)

This occurred during the election season. In the midst of the crisis, the nation voted for "hope and change" in the person of Democrat Barack Obama. It looked the most apocalyptic prophesies of Peak Oil might be coming true.

Next - Strange Days, the final chapter.

The Secret History of Oil and Money - Part 5

Paper Money was published in 1981, so the readers don't know what happened next. But we do, of course, because we are living through it. I'll try and sketch in the details briefly with the help of Wikipedia and a few other sources.

The late 1970s were a time of discontent. Jimmy Carter gave his "Crisis of Confidence" speech (sometimes called the "Malaise" Speech), Britain experienced the "Winter of Discontent," and the Soviet Union entered the Era of Stagnation. It all had to do with high energy prices. Oil, having driven the boom, and now the major energy source of the industrialized world, had risen tenfold in a decade bringing down the industrialized economies. The industrial nations were also heavily polluted in the late 1970's. Confidence in nuclear power, once seen as the energy source of the space age, evaporated at Three Mile Island in 1979, and later at Chernobyl. It seemed like the post-war Keynesian consensus had let everyone down.

1974-1975 was a terrible recession. Unions, hit by the cost increases, went on strike. Garbage piled up in the streets of New York City. In 1975, New York went into debt restructuring. There was even a spike in crime and lawlessness that defied explanation. Some have convincingly argued that the introduction of lead into gasoline to stop engine knock was the cause of the crime outbreak due to lead poisoning:

Fourteen years ago, Prof Jessica Wolpaw-Reyes, an economist at Amherst College Massachusetts, was pregnant and doing what many expectant mothers do - learning about the risks to her unborn child's health. She started to read up on lead in the environment and, like Nevin before her, began pondering its link to crime.

"Everyone was trying to understand why crime was going down," she recalls. "So I wanted to test if there was a causal link between lead and violent crime and the way I did that was to look at the removal of leaded petrol from US states in the 1970s, to see if that could be linked to patterns of crime reduction in the 1990s."

Wolpaw-Reyes gathered lead data from each state, including figures for gasoline sales. She plotted the crime rates in each area and then used common statistical techniques to exclude other factors that could cause crime. Her results backed the lead-crime hypothesis.

"There is a substantial causal relationship," she says. "I can see it in the state-to-state variations. States that experienced particularly early or particularly sharp declines in lead experienced particularly early or particularly sharp declines in violent crime 20 years later."

Did removing lead from petrol spark a decline in crime? (BBC)

The unions, striking to gain higher wages to cope with higher gasoline prices, came to be seen as part of the problem. Anti-union forces portrayed them as corrupt anachronisms holding back economic growth. They played up the corruption and ties to organized crime (true of a very small percentage of big city unions). I've always found this comical because it assumes that the enemies of unions - Wall Street, the corporate boardrooms, the big banks and the politicians--are somehow paragons of honesty and fairness. Give me a break. It's all corruption - it's just who benefits from it.

To some extent it was irrelevant. The opening of China (see below) led to the deindustrialization of the Industrial Heartland of America and the creation of the "Rust Belt." Entire swaths of the country became depopulated hellholes while politicians in both parties looked the other way. People were told that they had to go back to school to get more education (leading to the soaring costs of college as it became the  tollbooth to what remains of the middle class), and economists touted the "service economy," i.e. low-wage McJobs as the base of the employment pyramid in place of value-added manufacturing. Automation played a role here too, despite assurances that automation always creates more jobs than it destroys.

This also accelerated the flood of migrants to the Sunbelt.The settling of the sunbelt also changed political attitudes. Because of the hot climate, the Sunbelt was a fairly undeveloped agricultural backwater. Industry was historically located near water transport, rail transport, sources of timber, coal and iron ore, and nearby farmland to feed workers.  As industry left the United Sates, the geographical advantages of manufacturing cities dwindled. Most older industrial cities were built on ports, but trucking reduced the need to bring in goods by water or rail. Because the Sunbelt cities had little in the way of investment in existing infrastructure to maintain, they could offer low, low taxes to attract business, unlike the older cities of the Northeast, Upper Midwest and Ohio Valley which had infrastructure dating back to the 1800s. In addition, the lack of snow and the freeze-thaw cycle meant that infrastructure costs could be lower because roads and buildings did not decay as fast. As businesses moved, so did the people. Once air conditioning made it livable, people began to move to escape the harsh winters.

Thus Americans adopted the attitude of getting something for nothing that pervades American politics today. As long as new development was taking place, taxes could be kept low, attracting more people funding further development which kept taxes low and so on -  a classic feedback loop. But this accustomed Americans to expecting to pay very low taxes no matter what. In effect, the Sunbelt was built out as a giant Ponzi scheme that voters mistook for a permanent condition. As the American population moved to these low-tax, warm weather havens, they just assumed low taxes as a birthright giving rise to the “no new taxes” attitudes we see today. With economic expansion, no aging infrastructure, and no cold winters, it was easy to adopt the minimalist government/rugged individualist ethos of the original Sunbelt farmers and ranchers, no matter how incompatible with the new reality of air-conditioned offices and globalized corporations. As the American population center of gravity began to shift south and west, these political attitudes became the dominant force in American politics. (i.e. the “Dixiefication” of American politics).

The rise of the US sunbelt can be understood largely as a response to the emergence of widespread air conditioning, which made places that are warm in the winter attractive despite humid, muggy summers. It’s a gradual, long-drawn-out response, because location decisions have a lot of inertia; few people would choose de novo to live in the old industrial towns of upstate New York, but the existing housing stock and the fact that people have family and social networks prevent quick abandonment. So to this day temperature is a good predictor of state population growth.

Now, these states have several things in common besides high temperatures. They’re all very conservative. And all of them that were states before the Civil War were slave states. These commonalities are, of course, all interrelated. Hot states had slaves because they were suitable for planation agriculture; and today’s red states are, pretty much, the slave states of 150 years ago.

Now, all of this raises some interesting problems for the assessment of economic policy. Because they’re politically conservative, hot states tend to have low minimum wages and low taxes on rich people. And someone who is careless, cynical, or both, could easily take the faster growth of these states as evidence that conservative economic policies work. That is, charlatans and cranks can, all too easily, end up claiming credit for economic and demographic trends that are actually the result of air conditioning.

Charlatans, Cranks, and Cooling (Paul Krugman)

Beginning in the mid-1960s inflation increased rapidly. Now, inflation is of two kinds – cost push and demand pull. Demand pull is when the amount of money in circulation exceeds the amount of goods and services we can reasonably buy. This can occur from too much money or too few goods, as when rationing or a war takes goods out of production. Thus, the only result is for the things already in existence to cost more. Cost push is when a crucial input into production, such as land, labor, capital or energy, increases in cost. To keep profits steady, the producers must raise the prices of the things they sell.

It is thought that the Vietnam war began this acceleration. Taxes were not raised to pay for the war, so the money spent into existence for the war was not “umprinted” via taxes causing an increase in the amount of dollars with the economy at capacity due to the war. Military needs competed with civilian ones. The goods produced via government spending were mainly shipped to Southeast Asia and blown up. There were also some commodity shocks:

We have gotten so used to inflation now that we have forgotten what it was like to operate in an environment in which prices did not leap and sellers did not build in an extra piece for inflation. The inflation rate in the United States  in the first half of the 1960s was between 1 percent and 2 percent. 

So, while some elements of this story go back to 1928, and 1717, and 1913, 1965 makes a very good starting point. The economy was running at full capacity then, and the United States was escalating its presence in Vietnam. The planes and the jet fuel and the combat boots were going to cost something, and the bill had to be paid. But Lyndon Johnson chose to duck the explicit way, which would have been to raise the money in taxes.

President Johnson, as quoted by David Halberstam, said: "I don't know much about economics, but I do know the Congress. And I can get the Great Society through right now—this is a golden time. We've got a good Congress and I'm the right President and I can do it. But if I talk about the cost of the war, the Great Society won't go through. Old Wilbur Mills will sit down there and he'll thank me kindly and send me back my Great Society, and     then he'll tell me that they'll be glad to spend whatever we need for the war."

When the Council of Economic Advisers began to press him for a tax increase, Johnson summoned key members of the House Ways and Means Committee to ask their advice. But the figures he gave them for Vietnam were deliberately low, and with those figures the Ways and Means Committee let him go back to the council and say that he had gone to Congress and discussed it but could not get the votes.

With the civilian economy already operating at capacity military needs competed with civilian needs, army boots with civilian shoes, military industries with civilian industries, producing a classic excess-demand inflation: not enough goods. All wars must be paid for; in this case the tax was not explicit, a special tax, but implicit: inflation. So we began with the unpaid bill of the Vietnam War.

The inflation that President Nixon faced was modest by current standards, but at roughly 5 percent it was still double its pre-Vietnam standard. Classic medicine was spooned out: tighter credit, higher taxes. The economy slowed down, but the inflation didn't. It had more momentum than the medicine spooners figured. By August 1971 Nixon had to face a decision, just as Johnson had. The polls showed that Nixon was running behind Edmund Muskie in a potential reelection fight. So Nixon adopted a twofold approach: he ordered wage and price controls, and at the same time his fiscal policies stimulated the economy. Arthur Burns, who had picked zero as a good rate of inflation, was at the helm when the money supply ballooned, which led his critics to say that his goal was all pipe smoke. Nixon's tactic worked in its timing; at election time the economy was rosy and prices, by law, relatively stable. But once the election was over, the controls had to come off. The suppressed inflation burst forth again; all the businesses that had frozen their prices marked them up as soon as they were legally able to, and demand was high because of all the excess money around.

To the political moves of Presidents Johnson and Nixon you could also add the weather and the missing anchovies. The weather helped to produce a bad wheat crop in Russia, and the Nixon administration saw an opportunity to win some points from the farmers in the election. But it sold too much wheat. Once the Russians took their purchased wheat away, Americans scrambled to buy their own grain.

There is always some out-of-place variable like the anchovies. In this case the anchovies swam away from the coast of Peru, no one knows where to, and the fish that ate the anchovies followed them, and the fishermen came back without the fish, and the European cattle feeders who normally used fish meal as feed switched to grain, and flew to Minneapolis and occupied the hotel rooms the Russians were just checking out of. The result was an explosion in grain prices.

So our overture has political decisions and industrial inflation and agricultural inflation—a nice running head start, but so far, all very classic kinds of inflation, not enough goods for the money.

And while the hotels of Minneapolis were filling with grain traders, and the money was flowing and business was good, OPEC was yawning and stretching its muscles like an aroused leopard, and that is such a major change we will come back to it in a while.

Inflation is complex, as you can see, and all the simple stories about it are too simple. There are two simple factors involved, though, which you already know.

The first is that when you pay more dollars for something, one of your fellow citizens gets those extra dollars. Obviously. Our economy is already "indexed" to some degree. If it were perfectly indexed, everything would go up at exactly the same rate—wages and prices and dividends. So one problem is that some things go up more than others, leaving unhappy those who lag in the escalation.

The second point you already know is that things used to go up and down, and they don't do that anymore. They go up and up. Or they go up, pause, look around, and go up again.

The way economists put this is to say that wages and prices have lost their sensitivity to changes in business. Automobile sales may fall apart, but the price of automobiles doesn't go down, nor do the wages of auto workers. What do you think is going to get cheaper? Do you put off buying anything until the price comes down? Some things do get cheaper: electronic calculators, home computers, items whose technology is leapfrogging. Some things we don't notice much and don't complain about: toasters, electric alarm clocks. Everything else seems to go up: houses, shoes, doctor bills, tuition, cars, food, haircuts, lipstick, chewing gum. In a period of slack, prices are, the economists say, "sticky downward." When business improves, the prices unstick and go upward.

We don't really know why prices are sticky downward, but one probable reason is that this is the price we have paid for the prosperity and stability we have had since the Great Depression. If recessions are short and contained, sellers stand pat and wait for the upturn, to cover their costs. Unemployed workers draw their benefits; they usually don't go out and take any job at any price. But most businesses don't fire people when their sales slack off, because they think sales will pick up again and they don't want to lose good people to their competitors.

If businesses were as frightened as they were in the 1930s, they would sell at a loss and let their workers go, and workers would take any job. But we don't have that kind of fear as a motivation, and we certainly wouldn't want to have it.

In the past decade we developed not only inflation but the expectation of inflation, and that psychological force is easily the equal of all the technical economic forces. (pp.20-22)

Milton Friedman argued that inflation was caused by too much money floating around. “Inflation is always and everywhere a monetary phenomenon,” was his motto. Remember, this was the same guy who said OPEC would not last eighteen months. He did not believe in cost-push inflation. He believed that the ten-fold increase of the substance that came to literally underpin the entire industrial economy had no effect on inflation. It was just an excess of money. The cure was simple – get rid of the excess money. This view was called “Monetarism.”

There are two other elements in the story of paper money that sometimes carry the whole blame for inflation. Unless you're used to the terms, they can sound very abstract. The first such element is deficits in the federal budget: the government spends more than it takes in. There is one obvious way this adds to inflation. When the government doesn't take in as much money as it spends, it has to go to the marketplace and borrow the rest. In the marketplace it meets private borrowers, who might be borrowing to build new plants or new houses. When the government competes heavily with those borrowers, that competition forces interest rates up, and interest is one of the costs of doing business.

But some folks say more than that; they say all our problems would be solved if only the government balanced its budget. Before we agree to that, though, we have to see what the federal government does with its money. What if the federal government gave the money it borrowed to the cities and states? Sometimes the states are in surplus when the federal government is in deficit. So we have to take all the governments together, federal, state, and local; and match the inflation rate. Governments obviously ought not to be in deficit all the time, because then they are attempting to be the first beneficiaries of inflation: they borrow from savers and repay with cheaper dollars. If the government does not believe in the currency, who will? Lenders get more and more reluctant to lend to governments that borrow more and more. The government and its budget are indeed a problem, but not the only problem. 

The second element that some folks assign all the blame to is another part of the government: the Federal Reserve. Some folks" in this case are the monetarists, who can play many tunes on one fiddle string. They say, for example, that if the Federal Reserve kept the supply of money to a low, predictable rate, all else would follow. There's no question that a supply of money growing faster than the output of goods and services contributes to inflation. The Federal Reserve says it is committed to slowing down growth in the supply of money. Yet, in the Notes of this book, you will find a simple table of two measures of the money supply; in the past five years, inflation increases even as the money supply begins to contract. So the money supply alone is not the cause of inflation. The money supply, like energy, is a subject for arguments of theological intensity, and you can find a great deal already published if you wish to pursue this. 

Now, the reason economists don't believe in cost-push inflation is the same reason as they don't accept the role of energy in the economy. Oil is seen as just another commodity and one that is "only" 5 percent of GDP or so.

In the 1970's as inflation increased, the Federal Reserve did not want to raise interest rates too high. It wanted to pursue what was called “full employment polices” – they did not want to cause the widespread unemployment that a recession would cause. Even in the recession of '74-'75, unemployment was relatively low.

By contrast, Volcker would pursue a “tight money” policy. Instead of pursuing full employment as a goal, the message from the Federal Reserve to the nation’s employees was the same as Persident Ford’s alleged advice to New York City, “Drop dead.” This also coincided with aggressive anti-union attitudes signified by the firing of the striking air traffic control employees in 1981.

Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believed that inflation was tolerable because it meant the economy was growing and unemployment would be low. Their general belief was that an increase in the demand for goods would drive up prices, which in turn would encourage firms to expand and hire additional employees. This would then create additional demand throughout the economy.

According to this theory, if the economy slowed, unemployment would rise, but inflation would fall. Therefore, to promote economic growth, a country's central bank could increase the money supply to drive up demand and prices without being terribly concerned about inflation. According to this theory, the growth in money supply would increase employment and promote economic growth. These beliefs were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes.

In the 1970s, Keynesian economists had to reconsider their beliefs as the U.S. and other industrialized countries entered a period of stagflation. Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation.

When people think of the U.S. economy in the 1970s the following comes to mind:

    High oil prices
    Inflation
    Unemployment
    Recession

Indeed, the average price of a barrel of oil reached a peak of $104.06 (as measured in 2007 dollars) in December of 1979. In the 1970s, there was a two-year period of economic contraction as measured by gross domestic product (GDP) in year 2000 dollars (i.e. Real GDP): 1974 GDP contracted 0.5%, and in 1975, GDP contracted 0.2% and unemployment reached 8.5%. In 1980, GDP contracted 0.2%.

The prevailing belief as promulgated by the media has been that high levels of inflation were the result of an oil supply shock and the resulting increase in the price of gasoline, which drove the prices of everything else higher. This is known as cost push inflation. According to the Keynesian economic theories prevalent at the time, inflation should have had an inverse relationship with unemployment, and a positive relationship with economic growth. Rising oil prices should have contributed to economic growth. In reality, the 1970s was an era of rising prices and rising unemployment; the periods of poor economic growth could all be explained as the result of the cost push inflation of high oil prices, but it was unexplainable according to Keynesian economic theory.

A now well-founded principle of economics is that excess liquidity in the money supply can lead to price inflation; monetary policy was expansive during the 1970s, which could explain the rampant inflation at the time.

Milton Friedman was an American economist who won a Nobel Prize in 1976 for his work on consumption, monetary history and theory, and for his demonstration of the complexity of stabilization policy. In a 2003 speech, the chairman of the Federal Reserve, Ben Bernanke, said, "Friedman's monetary framework has been so influential that in its broad outlines at least, it has nearly become identical with modern monetary theory … His thinking has so permeated modern macroeconomics that the worst pitfall in reading him today is to fail to appreciate the originality and even revolutionary character of his ideas in relation to the dominant views at the time that he formulated them."

Milton Friedman did not believe in cost push inflation. He believed that "inflation is always and everywhere a monetary phenomenon." In other words, he believed prices could not increase without an increase in the money supply. To get the economically devastating effects of inflation under control in the 1970s, the Federal Reserve should have followed a constrictive monetary policy. This finally happened in 1979 when Federal Reserve Chairman Paul Volcker put the monetarist theory into practice. This drove interest rates down to double-digit levels, reduced inflation down and sent the economy into a recession.

Stagflation, 1970s Style  (Investopedia) Of course, Keynesian economics, like most economic doctrines, was ignorant of the role of energy in the economy, being mainly concerned with prices and money flows.

Through early 1978, the Federal Reserve had maintained a highly accommodative stance of monetary policy, hoping to combat rising unemployment. Ultimately, though, the policies showed little success in stifling the deterioration in the unemployment rate and likely fostered an environment that allowed the rising energy prices to be transmitted into more general inflation. Consumer inflation, which had already begun to accelerate in the United States, continued to rise—from below 5 percent in early 1976 to nearly 7 percent by March 1979. By that time, unease among members of the Federal Open Market Committee (FOMC) that inflation could continue to rise was growing. Records from the meeting of the FOMC on February 28, 1978, indicate that “considerable concern was expressed that the rate of inflation might accelerate significantly as the year progressed [and could] pose difficult questions concerning the appropriate role of monetary policy.” Nevertheless, the committee voted unanimously to keep the policy rate unchanged.

Despite increasing concern among the public and members of the FOMC about the declining value of the dollar and rising pace of inflation, the committee remained hesitant to raise interest rates too aggressively, fearful of stifling fragile economic growth. The Fed raised the federal funds rate from 6.9 percent in April 1978 to 10 percent by the end of the year. The increase was a clear move to try to curb rising inflation. However, modern economic historians now see the increases as timid and insufficient to stem a surge in inflationary pressure, which had already become entrenched in the American psyche and economy. Twelve-month consumer price index inflation rose to 9 percent by the end of 1979.

 The Carter administration’s decision to appoint Paul Volcker as Fed chairman in August 1979 was a strong endorsement of using more aggressive monetary policy to try to break inflation’s stranglehold on the US economy. As the president of the Federal Reserve Bank of New York, Volcker had been an outspoken proponent of using monetary policy to combat rising inflation. According to Volcker, “If all the difficulties growing out of inflation were going to be dealt with at all, it would have to be through monetary policy…. [No] other approach could be successful without a successful demonstration that monetary restraint would be maintained.” Volcker and the policy-setting FOMC made taming inflation their top priority, even if it came at the detriment of short-term employment. The policies ultimately proved successful in breaking the cycle of stagflation in the United States.

Volcker guided the Fed in raising the federal funds rate from 11 percent at the time he took office to a peak of 19 percent in 1981, and the policy moves successfully lowered the rate of twelve-month inflation from a peak of nearly 15 percent to 4 percent by the end of 1982. Though the Fed’s resolve under Volcker was effective in reducing inflation, the monetary contraction—combined with the impact from the oil price shock—pushed the economy into the most severe recession since the Great Depression and spurred strong popular opposition.

Oil Shock of 1978–79 (Federal Reserve History)

The Federal Reserve board led by Volcker is widely credited with ending the United States' stagflation crisis of the 1970s. Inflation, which peaked at 14.8 percent in March 1980, fell below 3 percent by 1983.

The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well. Thus, the unemployment rate rose to over 10%. The economy was restored since the tight-money policy was over in 1982. According to William Silber "His policy of preemptive restraint during the economic upturn after 1983 increased real interest rates and pushed Congress and the president to adopt a plan [the 1985 Gramm-Rudman-Hollings bill] to balance the budget. The combination of sound monetary and fiscal integrity sustained the goal of price stability."

However, despite the Gramm-Rudman-Hollings bill, US debt as a percentage of GDP more than doubled between 1981 and 1993.

Paul Volcker (Wikipedia)

...What we did have was a wage-price spiral: workers demanding large wage increases (those were the days when workers actually could make demands) because they expected lots of inflation, firms raising prices because of rising costs, all exacerbated by big oil shocks. It was mainly a case of self-fulfilling expectations, and the problem was to break the cycle.

So why did we need a terrible recession? Not to pay for our past sins, but simply as a way to cool the action. Someone — I’m pretty sure it was Martin Baily — described the inflation problem as being like what happens when everyone at a football game stands up to see the action better, and the result is that everyone is uncomfortable but nobody actually gets a better view. And the recession was, in effect, stopping the game until everyone was seated again.

The difference, of course, was that this timeout destroyed millions of jobs and wasted trillions of dollars.

Was there a better way? Ideally, we should have been able to get all the relevant parties in a room and say, look, this inflation has to stop; you workers, reduce your wage demands, you businesses, cancel your price increases, and for our part, we agree to stop printing money so the whole thing is over. That way, you’d get price stability without the recession. And in some small, cohesive countries that is more or less what happened. (Check out the Israeli stabilization of 1985).

But America wasn’t like that, and the decision was made to do it the hard, brutal way. This was not a policy triumph! It was, in a way, a confession of despair.

It worked on the inflation front, although some of the other myths about all that are just as false as the myths about the 1970s. No, America didn’t return to vigorous productivity growth — that didn’t happen until the mid-1990s. 60-year-old men should remember that a decade after the Volcker disinflation we were still very much in a national funk; remember the old joke that the Cold War was over, and Japan won?

The Mythical 70's (Paul Krugman)

The success of monetarism in bringing down inflation appeared to validate Friedman’s ideas, and hence those of the Neoliberal school. Economics papers began to adopt these ideas. The University of Chicago graduated more economists. Neoliberal and Austrian economists began to win Nobel Prizes (Bank of Sweden prizes).

All of these trends led led to the election of Ronald Reagan in 1980.

But Reagan had a secret weapon - the 1980's oil glut.

The proximate causes of the oil glut were that other non-OPEC oil producers, spurred by the higher cost of oil, flooded the market. This included Britain and Norway, Russia (then the Soviet Union), Mexico, Nigeria, and Canada, combined with reduced oil demand from the U.S. and Europe thanks to a combination of the poor economy and conservation measures. By lowering the amount of oil on the market, this spurred an increase in price, and this increase in price spurred the development of oil in non-OPEC countries. Not subject to artificial OPEC quotas, they began flooding the market which had been depressed by the recessions caused by high inflation and interest rates. Oil consumption did not pass its 1973 level until 1983.

Wikipedia has a good summary of the oil glut:

In April 1979, Jimmy Carter signed an executive order which was to remove market controls from petroleum products by October 1981, so that prices would be wholly determined by the free market. Ronald Reagan signed an executive order on January 28, 1981 which enacted this reform immediately, allowing the free market to adjust oil prices in the US. This ended the withdrawal of old oil from the market and artificial scarcity, encouraging increased oil production. The US Oil Windfall profits tax was lowered in August 1981 and removed in 1988, ending disincentives to US oil producers. Additionally, the Alaskan Prudhoe Bay Oil Field entered peak production, supplying the US West Coast with up to 2 million bpd of crude oil.

From 1980 to 1986, OPEC decreased oil production several times and nearly in half to maintain oil's high prices. However, it failed to hold on to its preeminent position, and by 1981, its production was surpassed by Non-OPEC countries. OPEC had seen its share of the world market drop to less than a third in 1985, from nearly half during the 1970s. In February 1982, the Boston Globe reported that OPEC's production, which had previously peaked in 1977, was at its lowest level since 1969. Non-OPEC nations were at that time supplying most of the West's imports.

OPEC's membership began to have divided opinions over what actions to take. In September 1985, Saudi Arabia became fed up with de facto propping up prices by lowering its own production in the face of high output from elsewhere in OPEC. In 1985, daily output was around 3.5 million bpd down from around 10 million in 1981. During this period, OPEC members were supposed to meet production quotas in order to maintain price stability, however, many countries inflated their reserves to achieve higher quotas, cheated, or outright refused to accord with the quotas.In 1985, the Saudis were fed up with this behavior and decided to punish the undisciplined OPEC countries. They abandoned their role as swing producer and began producing at full capacity, which created a "huge surplus that angered many of their colleagues in OPEC". High-cost oil production facilities became less or even not profitable. Oil prices as a result fell to as low as $7 per barrel.

Nonetheless, this was seen as irrelevant by the money/banking establishment who saw Volcker's "tight money" policy as the answer. This was seen to validate Milton Friedman's ideas, and hence Neoliberalism. Because of the glut, it seemed like Reagan's policies of tax cuts for the rich, deregulation of the banks, and suppression of unions was the key to prosperity, a gospel which is still believed by a majority to this day. Keynesian economics was seen to have been invalidated.

The corporate forces seized the opportunity to launch a counterrevolution that continues unabated to this day. The seeds had been sewn in the immediate postwar period by the establishment of the Mont Pelerin Society and the "Austrian" school, which attempted to rehabilitate unregulated markets in the aftermath of almost two decades of Depression and War caused by them. In 1971, Lewis Powell issued a memorandum calling on businesses to fight back and retake public opinion:

August 23, 2011 will bring the 40th anniversary of one of the most successful efforts to transform America. Forty years ago the most influential representatives of our largest corporations despaired. They saw themselves on the losing side of history. They did not, however, give in to that despair, but rather sought advice from the man they viewed as their best and brightest about how to reverse their losses. That man advanced a comprehensive, sophisticated strategy, but it was also a strategy that embraced a consistent tactic – attack the critics and valorize corporations!

He issued a clarion call for corporations to mobilize their economic power to further their economic interests by ensuring that corporations dominated every influential and powerful American institution. Lewis Powell’s call was answered by the CEOs who funded the creation of Cato, Heritage, and hundreds of other movement centers.

Bill Black: My Class, right or wrong – the Powell Memorandum’s 40th Anniversary (Naked Capitalism)

Here's David Harvey explaining the change:

SL: The welfare state was characterized by a compact of sorts between labor and capital, the idea of a social safety net, a commitment to full employment -- you call this "embedded liberalism."  Up until the 1970s it was supported by most elites.  Why was there a backlash against the welfare state and the push for a new political economic order in the 1970s that gave rise to the political implementation of neoliberal thought?

DH: I think there were two main reasons for the backlash. The first was that the high growth rates that had characterized the embedded liberalism of the1950s and 1960s -- we had growth rates of around 4 percent during those years -- those growth rates disappeared towards the end of the 1960s. That had a lot to do with the stresses within the US economy, where the US was trying to fight a war in Vietnam and resolve social problems at home.  It was what we call a guns and butter strategy.  But that led to fiscal difficulties in the United States.  The United States started printing dollars, we had inflation, and then we had stagnation, and then global stagnation set in in the 1970s.  It was clear that the system that had worked very well in the 1950s and much of the 1960s was coming untacked and had to be constructed along some other lines.  The other issue which is not so obvious, but the data I think show it very clearly, is that the incomes and assets of the elite classes were severely stressed in the 1970s.  And therefore there was a sort of class revolt on the part of the elites, who suddenly found themselves in some considerable difficulty, for economic as well as for political reasons.  The 1970s was, if you like, a moment of revolutionary transformation of economies away from the embedded liberalism of the postwar period to neoliberalism, which was really set in motion in the 1970s and consolidated in the 1980s and 1990s.

On Neoliberalism: An Interview with David Harvey (Monthly Review)

Neoliberal economics, a free-market fundamentalist cult, became the world's predominant economic theory, as Keynesian economics was marginalized along with its practitioners. Rather than government being seen as a necessary force in mitigating the inherently unstable capitalist system and ensuring a relatively equitable distribution of surplus, it was recast as the problem--an impediment to the growth that would fix all problems. Unregulated markets where rational consumers could operate and "allocate capital" to wherever it was needed was the key to prosperity, the thinking went.

The Neoliberal economists, proclaiming themselves validated by the events of the 1980s, took control of the world's economic institutions . Something called the Washington Consensus took shape, and its policies were dictated by the old Bretton Woods institutions -  the IMF, WTO and World Bank.

All tariffs would be abolished. Developing countries would be exposed to full competition from the heavily subsidized industries of the West. Workers in the West would now be in direct competition with workers everywhere, including in the the world's poorest countries. Even in the face of tax cuts on the rich, governments would no longer be allowed to run a deficit. Government spending, especially on vital social needs, would be curtailed. Debt crises caused selloffs of institutions to international investors who charged what the market would bear. Workers lost their pensions and were forced to invest in the unstable market for their retirement. Everyplace where these "reforms" were instituted, they were portrayed as great benefits for all. Economists proclaimed that the change was inevitable and irreverable. They pushed the idea of TINA - There Is No Alternative.

Reagan removed the solar hot water panels from the White House in 1986.

"Morning in America " unfolded alongside the 1980's oil glut.

The two largest Communist states realigned. The Soviet Union was already brittle, and the arms race with the U.S. had caused it to increase military spending. Gorbachev had begun to initiate tentative steps to reform, but was overtaken by events. When oil prices crashed due to the 1980's oil glut, the economy of the Soviet Union crashed along with it, as its exports could no longer fetch an adequate price on the world market. The Soviet Union collapsed in 1991.

The timeline of the collapse of the Soviet Union can be traced to September 13, 1985. On this date, Sheikh Ahmed Zaki Yamani, the minister of oil of Saudi Arabia, declared that the monarchy had decided to alter its oil policy radically. The Saudis stopped protecting oil prices, and Saudi Arabia quickly regained its share in the world market. During the next six months, oil production in Saudi Arabia increased fourfold, while oil prices collapsed by approximately the same amount in real terms.

As a result, the Soviet Union lost approximately $20 billion per year, money without which the country simply could not survive. The Soviet leadership was confronted with a difficult decision on how to adjust. There were three options–or a combination of three options–available to the Soviet leadership.

First, dissolve the Eastern European empire and effectively stop barter trade in oil and gas with the Socialist bloc countries, and start charging hard currency for the hydrocarbons. This choice, however, involved convincing the Soviet leadership in 1985 to negate completely the results of World War II. In reality, the leader who proposed this idea at the CPSU Central Committee meeting at that time risked losing his position as general secretary.

Second, drastically reduce Soviet food imports by $20 billion, the amount the Soviet Union lost when oil prices collapsed. But in practical terms, this option meant the introduction of food rationing at rates similar to those used during World War II. The Soviet leadership understood the consequences: the Soviet system would not survive for even one month. This idea was never seriously discussed.

Third, implement radical cuts in the military-industrial complex. With this option, however, the Soviet leadership risked serious conflict with regional and industrial elites, since a large number of Soviet cities depended solely on the military-industrial complex. This choice was also never seriously considered.

Unable to realize any of the above solutions, the Soviet leadership decided to adopt a policy of effectively disregarding the problem in hopes that it would somehow wither away.  Instead of implementing actual reforms, the Soviet Union started to borrow money from abroad while its international credit rating was still strong.  It borrowed heavily from 1985 to 1988, but in 1989 the Soviet economy stalled completely…

The money was suddenly gone. The Soviet Union tried to create a consortium of 300 banks to provide a large loan for the Soviet Union in 1989, but was informed that only five of them would participate and, as a result, the loan would be twenty times smaller than needed.  The Soviet Union then received a final warning from the Deutsche Bank and from its international partners that the funds would never come from commercial sources.  Instead, if the Soviet Union urgently needed the money, it would have to start negotiations directly with Western governments about so-called politically motivated credits.

In 1985 the idea that the Soviet Union would begin bargaining for money in exchange for political concessions would have sounded absolutely preposterous to the Soviet leadership.  In 1989 it became a reality, and Gorbachev understood the need for at least $100 billion from the West to prop up the oil-dependent Soviet economy.

Why did the Soviet Union fall? (Marginal Revolution)

In China, by contrast, the Communist party opened up their economy to the West in a controlled experiment. They exploited their bottomless pool of cheap labor and plentiful domestic coal to become the world's factory floor. The State retained control and controlled the development of the economy. American companies, looking for greater profits, packed up America's industrial base and shipped it to China, leading the low-wage Wal-Mart economy of today. Global wage arbitrage became recast as "free trade:"

...the news from China barely made a dent in the US in 1976. The Cultural Revolution was said to be winding down. Zhou Enlai died in February; an earthquake in Tangshan in July killed as many as 650,000 persons; Mao Zedong died in September. The Mandate of Heaven, an ancient governing concept in Chinese civilization, had, it was said, perhaps been lost. Americans were preoccupied with recovery from a recession, a presidential election, the bicentennial celebration of their Declaration of Independence; Europeans with their record-breaking hot summer.

Barely two years later, the Communique of the Third Plenum of the Eleventh Central Committee announced a plan to “shift the emphasis of our party’s work and the attention of the people of the whole country to socialist modernization.” People’s material lives must be improved, it declared; bureaucratic self-indulgence would not be tolerated. A “new Long March” would make China “a great modern socialist power” by the end of the twentieth century.

Lin was one of the very first movers in the epochal events that followed the third Plenum in December 1978. Millions followed, high and low, in accordance with Deng Xiaoping’s mantra, “Let some people get rich first.” By the end of the twentieth century, China was on the verge of becoming the second largest economy in the world. Average growth of ten percent for twenty years had lifted half a billion people out of poverty and changed the lives of countless others around the world.

Entry of China into the world trading system was only one of those once-small clouds to have swiftly grown into all-encompassing developments in the ’90s and ’00s. The advent of the computer was another; financial deregulation after Mayday 1975 was a third. These are the changes we are concerned with here. Still others – gender convergence, for example – have only just begun to have their impact gauged.

“A small cloud, no bigger than a man’s hand…” (Economic Principals)

The flood of cheap goods from China offset workers' falling wages, once again giving a fig leaf to Neoliberal economics. The effects on Latin America, however, were a"lost decade" in Mexico caused by falling oil prices and a debt crisis throughout Latin America. It was these crises that drove the drug wars and poverty in Latin America. The response from international institutions was the full implementation of harsh austerity measures and the "disaster capitalism" of The Shock Doctrine.

When the world economy went into recession in the 1970s and 80s, and oil prices skyrocketed, it created a breaking point for most countries in the region. Developing countries also found themselves in a desperate liquidity crunch. Petroleum exporting countries – flush with cash after the oil price increases of 1973-74 – invested their money with international banks, which 'recycled' a major portion of the capital as loans to Latin American governments. The sharp increase in oil prices caused many countries to search out more loans to cover the high prices, and even oil producing countries wanted to use the opportunity to develop further. These oil producers believed that the high prices would remain and would allow them to pay off their additional debt.

As interest rates increased in the United States of America and in Europe in 1979, debt payments also increased, making it harder for borrowing countries to pay back their debts. Deterioration in the exchange rate with the US dollar meant that Latin American governments ended up owing tremendous quantities of their national currencies, as well as losing purchasing power. The contraction of world trade in 1981 caused the prices of primary resources (Latin America's largest export) to fall.

While the dangerous accumulation of foreign debt occurred over a number of years, the debt crisis began when the international capital markets became aware that Latin America would not be able to pay back its loans. This occurred in August 1982 when Mexico's Finance Minister, Jesus Silva-Herzog declared that Mexico would no longer be able to serve its debt. Mexico declared that it couldn't meet its payment due-dates, and announced unilaterally, a moratorium of 90 days; it also requested a renegotiation of payment periods and new loans in order to fulfill its prior obligations.
....
After the petroleum boom previous to the government of Mexican president José López Portillo (from 1976 to 1982), Mexican government began to rely heavily on export barrels to support the financial needs in the country. These exports were mainly directed towards the United States, mainly due to the petroleum crisis of 1973, taking advantage of the high prices these barrels garnered.

When the market finally settled, thus reducing the high prices per barrel, the financial stability of the country was endangered. Diversification of income would have prevented the problem, but due to the inability of other production sectors to make up for the reduced profit, Mexico had to inflate the currency to by then historic levels. The Mexican peso would then be devaluated by a 500%.
...
In the wake of Mexico's default, most commercial banks reduced significantly or halted new lending to Latin America. As much of Latin America's loans were short-term, a crisis ensued when their refinancing was refused. Billions of dollars of loans that previously would have been refinanced, were now due immediately.
...
The banks had to somehow restructure the debts to avoid financial panic; this usually involved new loans with very strict conditions, as well as the requirement that the debtor countries accept the intervention of the International Monetary Fund (IMF)...

Before the crisis, Latin American countries like Brazil and Mexico borrowed money to enhance economic stability and reduce the poverty rate. However, as their inability to pay back their foreign debts became apparent, loans ceased, stopping the flow of resources previously available for the innovations and improvements of the past few years. This rendered several half-finished projects useless, contributing to infrastructure problems in the affected countries.

During the international recession of the 1970s, many major nations and countries attempted to slow down and stop inflation in their countries by raising the interest rates of the money that they loaned, causing Latin America's already enormous debt to increase further. In between the years of 1970 to 1980, Latin America's debt levels increased by more than one-thousand percent.

The crisis caused the per capita income to drop and also increased poverty as the gap between the wealthy and poor increased dramatically. Due to the plummeting employment rate, children and young adults were forced into the drug trade and prostitution. The low employment rate also caused many problems like homicides and crime and made the affected countries undesirable places to live. Frantically trying to solve these problems, debtor countries felt pressured to constantly pay back the money that they owed, which made it hard to rebuild an economy already in ruins.

Latin America, unable to pay their debts, turned to the IMF (International Monetary Fund) who provided money for loans and unpaid debts. In return, the IMF forced Latin America to make reforms that would favor free-market capitalism. The IMF also helped Latin America utilize austerity plans and programs that will lower total spending in an effort to recover from the debt crisis. The efforts of the IMF brought Latin America's economy to become a capitalist free-trade type of economy which is a type of economy preferred by wealthy and fully developed countries.

Latin American Debt Crisis (Wikipedia)

La Década Perdida (Wikipedia)

Mexico signed onto NAFTA and Mexican farmers were exposed to competition from imports of America's heavily-subsidized corn (also cheap thanks to gasoline-powered agriculture - Mexican farms were less mechanized). The destruction of the rural Mexican economy sent millions of economic refugees from the beanfields into "El Norte" in the nineteen-nineties searching for work that Americans "wouldn't do," or rather, wouldn't do for the prices employers wanted to offer. This was another win for Neoliberalism as this drove down working class wages in the U.S.

Thus the "Neoliberal Revolution" of the 1980's and 1990's across the world was underpinned by the price of oil from expensive to cheap.

In 1981, before the brunt of the glut, Time Magazine wrote that in general, "A glut of crude causes tighter development budgets" in some oil-exporting nations.In a handful of heavily populated impoverished countries whose economies were largely dependent on oil production — including Mexico, Nigeria, Algeria, and Libya — government and business leaders failed to prepare for a market reversal.

With the drop in oil prices, OPEC lost its unity. Oil exporters such as Mexico, Nigeria, and Venezuela, whose economies had expanded in the 1970s, were plunged into near-bankruptcy. Even Saudi Arabian economic power was significantly weakened.

Iraq had fought a long and costly war against Iran, and had particularly weak revenues. It was upset by Kuwait contributing to the glut and allegedly pumping oil from the Rumaila field below their common border. Iraq invaded Kuwait territory in 1990, planning to increase reserves and revenues and cancel the debt, resulting in the first Gulf War.

The USSR had become a major oil producer before the glut. The drop of oil prices contributed to the nation's final collapse.

Oil would continue to be relatively cheap throughout the 1980's and through the 1990's, once again making Neoliberalism seem the key perpetual prosperity. "Between November 1985 and March 1986, the price of crude plunged by 67%. ..After the mid-1980s bust, it took nearly two decades for oil prices to rebound to pre-bust levels and remain there." (http://www.wsj.com/articles/back-to-the-future-oil-replays-1980s-bust-1421196361).

All that would change however. Certain organizations had predicted a global peak of oil sometime abound 2006...

The Secret History of Oil and Money - Part 4

Last time we saw that a series of events had managed to move the power from the oil companies to the oil producing states via OPEC. They used that power first to get an increase in the price in 1970, and then increase it again and add an embargo in 1973. We also saw that in 1971, the amount of Eurodollars floating around caused the U.S. to sever the ties to gold and let currencies float. This meant that there was no limit on the money that could be printed to pay for the oil. The problem was that the money represented real claims against the West. With the increase in price, there was no way the West could sell anything to these essentially undeveloped countries to balance out the money they had to pay to get the oil.

The owners of the oil, everywhere in the world, were four times as rich after Tehran; soon they would be ten times as rich. 

The West Germans, the thrifty, hard-working West Germans, had gone to the office and the factory, and hammered and blowtorched and bolted, and they had infested the world with their Beetle Volkswagens, their machinery, and their chemicals, and they had earned, by 1975, a surplus of $40 billion.  

And the Japanese, with their beehive cooperation, had gone to the factory early in the morning and sung "Hail to Thee, O Matsushita," the company song, and done their group calisthenics, and hammered and buzzed around and swamped the world in television sets and stereos and cameras and little cars, and after years of work they were on their way to multibillion-dollar surpluses.  

The United States and Britain and Italy didn't have any such surpluses at all (though the United States did have the long-term investments from its key-currency heyday). And now, suddenly, one country—one family—had an exchange surplus of $60 billion! Without even working!

While sitting in a gas line, Smith ponders the question asked by the Hungarian banker - if the price of oil had quadrupled, where do we get the money to pay for the oil that we need?

First I thought, This gas line is burning up a lot of gas just trying to get more. Then: How do we pay for the oil quadruple? That is, we, the United States? Well, we could sell something to the Arabs. What are we good at growing or making and selling? Aircraft, wheat, soybeans, maybe some high-technology equipment. Now, what are they buying? Who's in OPEC? We can forget Gabon and Ecuador and Qatar—not significant. Who are we talking about? Iraq: cross off, no relations with them. Libya, Kuwait, Saudi Arabia, Iran. Libya: fewer than 2 million people. Kuwait: fewer than 300,000. Saudi Arabia: 6 million. Small countries. Don't have big airlines. Sell a couple of 727s, a 747 or two; that's about enough oil for ten minutes of gas lines. Wheat, soybeans—small countries don't eat much; we have 120 million cars, each car is sitting in a gas line with its motor running; you could sell all the wheat and soybeans Libya, Kuwait, and Saudi Arabia could eat and only move the whole national gas line one block. Less. Maybe thirty feet. Of course, Iran ... 33 million people. Shah—aircraft? A couple more airplanes, a little more wheat—aircraft, arms. We could sell arms to the Shah. 

But not enough to the other folks. No, what we will buy the oil with is dollars, because the world takes dollars, trades in dollars. And the oil folk will have the dollars, and then they can come and buy what they want. But nobody realizes the scale. Let's just say we pay the import price for half of the oil needs, at let's say, $10 a barrel, carry the 3, times 365 days in the year; my goodness, in one year OPEC could have $100 billion extra, maybe $200 billion soon, then they could come and buy half of the stocks on the New York Stock Exchange, almost half. And that's only one year. The next year the 120 million cars are back at the gas pump, and OPEC has another $100 billion, and they keep piling up those claim checks until they can buy the whole New York Stock Exchange. They keep the claim check, and we move the cars around. We are going to sell America for a product that burns up in the atmosphere. We will be a colony...

The triumph of the Club is something quite unparalleled in history. When else was there such a transfer of wealth? When the Spaniards brought back the gold and silver of Peru? When the British raj (sic) ruled India?

Smith discusses a rumor that Nixon actually wanted the price of oil to go up. Why? To arm the Shah of Iran and keep the Middle East in balance.

Nixon and Kissinger stopped off in Iran on the way home from the Moscow summit in 1972. What they saw was a dangerous situation. The British had withdrawn from the Persian Gulf at the end of 1971; the United States was still involved in Vietnam. There was a power vacuum in the strategic Middle East. The Shah could take it over and would get the arms to do so.  

How would the Shah pay for the arms? By raising the price of oil. No American Congress would have voted billions to arm Iran, it was thought, while troops were still in Vietnam. James Akins reported that the Saudis were worried both by the Iranian buildup and by the prospect of a high price for oil, which they thought would damage the stability of the West, on which their bank accounts and survival depended.

Smith ultimately discards the theory:

If a quadrupled oil price was the cost of arming the Shah, it was one of the most expensive blunders in history. The scale of the transfer of wealth is hard to comprehend, and in this instance the arithmetic makes no sense. If $90 billion a year sounds silly divided into orange juice, it does not make much more sense divided into F-14s...the West could transfer to OPEC one air force, one navy, and still owe $100 billion every year.

The Western industrial economies now had the worst of both inflation and recession. Normally inflation is caused by an overheating economy, not one where people are worried about their jobs and how to pay for things.

The higher oil prices acted as a fiscal drag, a tax. Higher prices for oil meant higher prices for fertilizer and plastics as well as gasoline and heat. If your gasoline bill and your heating bill and your food bill went up, you might defer buying a car; then the automobile manufacturer laid off  some workers, who in turn cut back on their own purchases. The recession of 1974-75 was the worst since the Depression of the 1930s.
And at that same time, inflation went up sharply. In the United States direct and indirect energy costs amount to 10 percent of pretax household income. A 100-percent rise in energy costs meant 10-percent inflation, all by itself. Not all the energy was oil, and not all oil came from the Middle East; but the price of OPEC oil had just gone up 400 percent, and the OPEC price became the world price.

In those days, unions still had power. As gas prices rose, unions demanded wage increases to compensate. Workers did not want to take the hit to their disposable incomes just to get to work. Employers granted the wage concessions, but raised prices to protect profits. This increase in prices caused the unions to once again demand higher wages and so on. A feedback loop was created, sometimes called a wage-price spiral. 

Unions were unafraid to go on strike when their demands were not met, leading to disruption of everyday life. The garbagemen went on strike in New York city causing garbage to pile up and fester in '68, '74 and '81. Coal miners went on strike in England, crippling the economy and leading to the introduction of rationing and a three-day workweek in 1974. This led to the changing attitudes toward unions during this period. Unions, once seen as stalwart defenders of the Middle Class, were seen as causing major inconveniences to the public, and the public mood turned against them. Corporations saw this as an opportunity and unleashed a relentless barrage of anti-union propaganda, playing up their ties to organized crime and depictingthem as corrupt anachronisms that defended lazy workers.

A series of radical energy conservation measures were adopted. Vehicle fuel economy standards were raised. Building efficiency standards were raised; insulation was mandatory. Travel went back to necessity only. The Strategic Petroleum Reserve was created, as was the International Energy Agency (IEA). Government studies looked at energy conservation measures and renewable energy. The speed limit was lowered to 55 MPH and Daylight Saving Time was introduced. For the first time ever, demand for oil fell. The oil usage in 1973 would not be seen again for a decade.

Americans did their part too. Solar "cheese wedge" houses spring up and people turned to the Whole Earth Catalog. The first commercial photovoltaic sells were sold and people experimented with wind energy. American consumers bought small fuel-efficient Japanese cars instead of American gas-guzzlers (the Japanese had no oil reserves and thus had to be efficient). This began the decline of the American automobile industry.

America was dealing with the energy crisis, but it was about to get a whole lot worse. In 1979, the Shah of Iran fell in a revolution led by the religious leader Ayatollah Khomeini. Iran became a theocracy hostile to the West. The American embassy staff was held hostage. Iranian oil production fell from 6 million barrels to 1.2 million barrels, a loss of 4.8 million barrels.

But the loss of oil was not the major problem - the problem was the wave of speculation on the markets caused by the unexpected loss that drove up the price of oil. Normally, oil is traded in a complex series of futures contracts. But there is also something called the spot market. Prices are settle in cash on the spot based on current values as opposed to forward prices, and delivery is expected within a month (Investopedia). In other words, it is immediate oil for short term needs. And by 1979, there were no cusions anymore, so the spot market became the go-to source.

As more and more countries went to the spot market to get oil, speculation drove the price up. The fear of further disruption spurred widespread speculative hoarding. Seeing the higher prices offered, oil sellers went to the spot market to sell in order to take advantage of the higher prices. To deal with this, OPEC raised the price of oil to the spot market price, causing another price shock.

Until the Shah fell, there was a modest surplus of oil in the channels of the world. Higher prices had forced some cutback in demand, and there was additional oil from Alaska and the North Sea. OPEC watchers noted that the cartel was getting less real money, because the Western currencies were depreciating faster than the oil price was going up.

But Iran was among the large producers, at 6 million barrels a day, and when the Shah was deposed, production from Iran's oil fields dropped to a fraction of the previous totals. That missing 6 million barrels a day was enough to create a shortage again, and the scramble resumed.

In the oil trade the "spot" market is called "Rotterdam," because oil can be bought, on a daily basis, from the huge tankers anchored in the Rotterdam harbor. The "Rotterdam" market, though, is all over the world. It is really the Telex through which the trades are made...The Iranian shutdown had made supplies tight. The Israelis and the South Africans could no longer buy Iranian oil, and they were looking for oil wherever they could find it. The Italians had only two weeks' worth of supply in the tanks, and the Spaniards and the Swedes were also low.

The new Iranian regime, with no loyalty to the old contracts with the Seven Sisters, began to sell to the "spot" market. On Monday, May 14, 1979, the Iranians sold oil at $23 a barrel, above the posted OPEC price of $13.34. On Tuesday it was $28. On Thursday it was $34. Ironically, the Seven Sisters were among the bidders; a subsidiary of Texaco secretly made a deal for 2 million barrels at $32. At Kharg Island in the Persian Gulf, there was the usual long line of tankers waiting to take on Iranian oil. The tankers with long-term contracts were told to stay anchored. (They were paying, incidentally, $35,000 a day in parking fees.) The tankers with "spot" contracts went right to the head of the line.

Not surprisingly, the "spot" market began to attract the oil. American oil companies with refined oil in the Caribbean began sending it to the "spot" market, seeking to maximize profits. The price in the "spot" market went as high as $42 a barrel.

Other OPEC nations pulled some oil from long-term contracts and sold it in the "spot" market. Some of the OPEC nations saw the dangers. OPEC was losing control! Libya and Algeria broke the $23.50-a-barrel ceiling set by the cartel. "Prices are out of control," warned Ali Khalifa al-Sabah, the oil minister of Kuwait. OPEC was breaking apart, but on the up side. No one had thought of that.

At the Department of Energy in Washington, officials totted up supply and demand. There should have been an excess of a million barrels a day, so why were prices going up?" The spot price reflects uncertainty, not shortage," said one analyst there.

The First Oil Crisis, in 1973-74, took oil from $2.69 to $11.65 a barrel, about a quadruple. The Second Oil Crisis, following the arrival of the Ayatollah Khomeini, produced roughly a double, to about $28 a barrel in 1979.

The Club was keeping up the game that worked so well: Leapfrog. Cut back the production, and supplies will be tight. Cut back the deliveries, and the oil consumers who can't get oil will go to the "spot" market, which is relatively small compared to the volume of world oil. The price in the "spot" market pops up. Then you say, well, that's the true value of oil, and you call a meeting of the oil ministers and move the OPEC price of oil up toward the "spot" market price. But if the "spot" market moves down again, you don't move the official price back down, because now you have a new long-term OPEC price. And you have room to do this because, taking OPEC as a whole, you need only 22 million of your 30 million barrels a day to pay your bills. The other 8 million barrels are "discretionary," and you can mess around with them, shut in some of them if necessary. Yet Leapfrog was not designed by OPEC ministers; they merely followed political events and took advantage.

Instead of Eurodollars, the world now had to worry about Petrodollars, since oil was denominated in dollars. Where would all those dollars go? They went into Western banks, by-and-large. But with the world in recession due to high oil prices, to whom could banks lend all that money to? Finding uses for all that money was termed Petrodollar recycling.

This problem is called Recycling the Petrodollars. The connection between the Sauds and the Rockefellers is that the Saud family puts its money in the Rockefeller family bank. Then the Rockefeller family bank lends the money around the world, sometimes to the people who need more money to pay the Saud family the new price of oil. Gertrude Stein said once that the money is always the money, only the pockets are different.
If the oil consumers could sell enough to the oil producers, the trade would come out even. If the Kenyans could raise the price of their coffee enough to pay for the increased price of gasoline and fertilizer, and the Saudis would drink enough coffee at the higher price to match that, no problem. But there aren't enough Saudis to drink that much coffee at any price. As we've seen, the oil producers who are "low absorbers" can't buy enough to make up for all the petrodollars they've suddenly earned.  

Ordinarily, oil should be a commodity like any other. But the current scale of the oil transfers, sent through the banks, creates more money.  

A higher price for oil sucks money out of an oil-consuming country. That country then has less money to spend for cars and apples and gasoline. Less money, less activity. recession, unemployment. Deflation—the oil price increase acts like a tax. In the oil-consuming country there is less money; in the oil producer there is more. So far it balances.  

Things being what they are, the tendency is for the oil consuming country to print a little more money to ease the pain of recession. That's politics, not economics or banking. Sending out real assets for the oil means very hard work. The central banker himself may want to tough it out, but the prime minister is already under attack by the labor unions and the parliament is restive.  

The oil producer still has the money paid for the oil, though, and doesn't need it. Into the bank it goes. Now the bank has a deposit, let's say, just to reverse all that OPEC gigantism, of $100. The Federal Reserve says that bank has to keep 10 percent deposit as a reserve. You walk in and borrow $90. You put that money in your checking account; now it's a deposit there, and your cousin Charley can walk in and borrow $81, because that fractional reserve is set aside each time. Your cousin Charley deposits his loan in his checking account, and the bank lends $72.90 to the next borrower. That's the way the multiplier works, and it keeps on going. If the Federal Reserve wants more money in the banks, it lowers that fractional reserve, so that you can borrow and your cousin Charley can borrow $85.50 instead 1. If the Federal Reserve wants there to be less money, it raises that fractional reserve.  

Question: What's the multiplier in Euroland? Theoretically, it's infinite. The Rockefeller bank of Euroland gets an OPEC deposit of $100, and it can lend the whole $100 to you; and when you deposit the $10U in the Deutsche Bank Luxembourg, that bank can lend the whole $100 to your cousin Charley, who puts it into the Banco d'Espagna of Euroland, and so on, so the original OPEC $100 gets quite a bit of mileage.
243-247

It turns out that what they did with the money was loan it out to Third-World Countries for development. That's right - the Third World Debt crisis you heard so much about a few years ago from the likes of Bono et alia had its origins in the massive influx of petrodollars into Western banks at a time of stagnant economies and high inflation:

Ironically, the struggle after 1979 to limit inflation by raising interest rates created a problem for the policy's instigators, the financial institutions, because it created a gulf between the amount money could earn if invested in a typical productive project and the rate of interest the entrepreneurs behind those projects were being asked to pay. Moreover, because the interest rate rise had produced a recession, very few of the institutions' domestic customers wanted to borrow anyway, except, as we have just seen, to pay their interest bills or to stave off collapse. The banks' problem of what to do with their funds was compounded because, as a result of the oil price rise, most OPEC countries had more money than they knew what to do with, having moved from having a small balance of payments deficit of $700 million in 1978 to a surplus of $100,000 million in 1980. Much of this money had been put in British and American banks on deposit.

To find a home for the OPEC cash as well as their own, bankers literally packed their suitcases and flew to the Third World. During a meeting of the Inter-American Development Bank in Madrid in 1981 senior bank officers queued up to offer funds to the man in charge of Mexico's borrowing as he lounged in an armchair at his hotel. A year later Mexico had borrowed so much that no-one was prepared to lend it more to repay old debts as they became due. It threatened to default, alerting the world the crisis the banks had created.

The bankers offered money to potential Third World borrowers at a price based on     based on the London interbank offered rate (LIBOR) plus 1 per cent. This meant that, if world interest rates increased, the rate of interest payable by the borrowing country did as well. It was a lazy man s way ot doing business because it made it impossible for borrowers to calculate the return they had to get from the projects for which they wanted the loans and the risk they were running by taking the loans on. However, the bankers thought their interests would be secure whatever happened to their borrowers' projects and rarely investigated them thoroughly. What mattered was that their profits in the  current year would be satisfactorily increased by the fixed margin they creamed off the top of the loan as a charge for agreeing to grant it. As for the future - well, as one banker, Walter Wriston, said at the time, countries don't go bankrupt, do they?

A factor that added to the banks' dangerous complacency was that they had done some Third World lending to recycle Middle Eastern funds after the 1973 oil price shock. These had generally worked out well, largely because the prices of the commodities exported by the borrowers had increased at an annual rate which exceeded the rate of interest being charged. In other words, there was no overall change in the relative wealth of borrower and lender throughout the period. The debt/export ratio had stayed constant and there was a net inflow of funds to most developing countries.

In the early 1980s, however, the deliberate contraction of demand in the United States and the EC caused commodity prices to plunge while the interest rates the producing countries had to pay were kept high, Consequently, rather than the wealth of both parties increasing in step, as had happened previously, money - or rather, claims on money - flowed from borrower to lender each year between 1981 and 1986 at a rate equivalent to interest at 20 per cent. As a debt doubles every 3.5 years at an interest rate of 20 per cent, the inevitable result was that these countries' ratio of debt to GNP tripled by 1987, although almost no new money was lent.

After the debt crisis became public in 1982 the value of the banks' Third World loans was gradually written down, involving them in showing huge losses. At the time of writing (1993), however, debtor countries have still not been released from their obligation to pay the full amount due, although some have been able to buy up some of their debt at a big discount on the secondary market where it was sold by smaller banks anxious to get cash for a very doubtful asset.

Richard Douthwaite; The Growth Illusion, pp. 67-68

Oil prices went up by a factor of ten in a decade. Right now the price of oil is about $45.00 a barrel, relatively cheap. Imagine looking at $450.00 a barrel oil in less than ten years and ask yourself what that would do. By 1981 unemployment was up over 10 percent and the economy was worse than at any time since the Great Depression. Unfortunately, it is here that Adam Smith's narrative stops.