Financial Sector Turmoil - By Dr. M. P. Wagle

Currently, the world financial sector is in turmoil. Governments continue to pour huge money to bail out the finance companies out of the crisis. While some experts have begun to identify causes for current turmoil, none of them offers convincing explanation.

In reality, rapid rise in the crude oil price since 2004 leading to excess liquidity fueled the crisis. The average annual oil price which was $ 28/barrel in 2003 rose to $ 36/barrel in 2004, $ 51/barrel in 2005, $ 61/barrel in 2006, $ 69/barrel in 2007, $ 109/barrel in 2008. The peak reached in July 2008 when it crossed $ 131/barrel. Consequently, profitability of oil extraction increased to an unprecedented level. Taking into consideration the break-even price of $30/barrel for Saudi Oil revealed by Steve Austin in his paper “Profitability and $ 100 Oil”, profitability of oil mining shot up from 16.7% in 2004 to 68.8% in 2005, 103.6 in 2006, 130.3% in 2007 and 262.1% in the current year of 2008. Though the price has been on decline since then, profitability continues to be high. Even by the most pragmatic calculations, and assuming Saudi break-even oil price of $ 30/barrel, the oil rich countries are likely to reap whopping profit of around $ 2.1 trillion in 2008 alone. The international banks activated these profits. Crude price rise was arrested and began to fall when the banks were no longer inclined to accept deposits owing to excess liquidity.

Causes of financial sector crisis
Demand for the energy products including crude oil is inelastic and does not contract even if the price goes up substantially. Secondly, natural gas and crude oil are the most preferred energy options owing to the lower capital cost per unit of energy produced, ease of handling and transportation, lesser impurities and comparatively easier technologies. Thirdly, demand for the crude oil based products continues to rise on account of their use for cooking purpose fueled by unprecedented rise in world population and surge in industrial production and transportation induced by ever rising world income. Net of energy cost, income of billions of people all over the world decreased, caused by the rapid rise in the oil price. Consequently, consumption of rest of the products excluding necessities of life (food, fuel, medicine and medical services) and accounting for a large share in world demand got suppressed from its optimum level. On the other hand, income of a few oil producing countries got enormous boost driven by the most powerful implied supply monopoly made possible by the oil cartel. In the process, world savings jumped up dramatically far above the optimum level. Being concentrated in the hands of a small segment of world population, these savings got further boost. Thus, while global consumption slipped below its optimum level thereby curtailing investment demand also, savings went up far above the optimum level and have been lying ideal for want of corresponding matching outlets. Resulting mismatch led to huge liquidity (cash surplus) with investment banks. Pressed to utilize excess funds, these banks offered loans without proper scrutiny, thereby leading to the collapse of the financial sector.

Policy options:
As the world economy is dominated by oil, it is desirable to identify likely policy options. Unfortunately, the problem is devoid of any solution owing to unviable technologies currently available for producing oil substitutes. Political system steadfast with legacy of vote bank all over the world including USA proves a stumbling block in pursuit of early solution. Moreover, fast depletion of oil and natural gas reserves is all set to play havoc in future. Whatever the actions are taken by the Governments so far, the problem will persist for long as no viable option to diffuse oil domination in the energy basket is on the horizon. Governments should therefore cross-subsidize solar, wind and other renewable sources of energy by taxing crude oil based products. This may perhaps reduce world’s dependence on crude oil for energy to some extent, thereby weakening hold of the oil cartel on global economy. Until then, some sort of debacle in the world financial sector will continue to surface intermittently.