Why oil prices are so high and will remain high

If you live long enough then history repeats itself. In the late 1970s I was an economics student at Oxford University and used to grill my tutors on the reasons for runaway inflation and the high oil price.

Eventually they would hand me a particularly difficult book on monetary theory like the one by Dornbusch and Fischer, two American academics whose theories continue to baffle students to this day. I notice their most recent publication was in 2003 and has yet to receive a single review on Amazon.com, as presumably modern students still find them tough going.

However, by 1979-80 we had been through almost a decade of rising oil prices and rampant inflation. You had to ask what had caused it. The most obvious cause was the Arab oil embargo of 1973, which quadrupled prices. But if you looked at price trends then oil had been heading upwards before that. Then as now we talked about energy conservation and fuel efficiency, and how oil supplies might actually run out in the early 21st century.

But when you really dug into the background of inflation and high oil prices it was an economist called Milton Friedman, greatly admired by the ilk of Dornbusch and Fischer, who seemed to have the answer: money supply inflation. If you looked at the money supply growth figures for the early 1970s they were off the scale, due to unfettered and largely incompetent lending by banks. Does that sound familiar? The sub-prime crisis has more than an echo of the secondary banking crisis of the 1970s, which also followed a collapse in property prices.

The problem is that to stop a financial crisis turning into a second Great Depression the only answer is to pump more money into the system to keep it afloat. This happened in the mid-70s and inflation moved still higher while the banking system tottered but did not fall, although admittedly the stock market was virtually wiped out in one of its worst-ever collapses. That is perhaps the next stage of the present crisis.

It was not until 1978 when Paul Volcker arrived at the Fed that monetary inflation was seriously addressed and a round of interest rate rises began. Inflation is difficult to put back into the bag once it has escaped, and time lags on monetary indicators are long, so it was not until the early 1980s that inflation subsided, and only at the cost of a nasty recession.

Indeed, inflation in the UK did not peak until 1980 despite Thatcher's application of monetarist discipline. And it was still only in that year that oil prices topped out. This is why I do not see oil prices weakening very much over the next few years, and possibly spiking to $150-200. That is what the bright analysts at Goldman Sachs say, and if you come from a monetarist school this is a very obvious conclusion. Within the global financial system the value of all outstanding derivatives now stands at more than $1,000trn (Dh3,670trn) with particularly strong growth in the first quarter of this year. Derivatives are synthetic financial products derived from real assets which rely on the continued creditworthiness of the counterparties. If one of the counterparties goes bankrupt then a chain of international investment banks, banks and financial entities will fail, causing systemic failure in the banking system.

This is a house of cards that can not be allowed to fall, and so whatever amount of money is needed to support this system will be found. Now as monetarists propound, monetary inflation always comes before commodity and consumer price inflation, and has been its primary cause in economic history from ancient Rome to the 1970s.

In this environment new money that should be propping up slumping property values and recapitalising the banks actually finds its way into the commodities complex where it chases the best returns in a self-fulfilling investment cycle.

And the more money that is pumped into support the banking system and its bad loans, the more money actually fuels inflation. More money is chasing goods and services, and so prices go up.

Nothing can halt higher and higher oil prices in this scenario, and energy prices will be far better supported in an actual global recession than anybody imagines today. We saw it all before in the 1970s, and the explanation is the same as the one I teased out of my economics dons then, and could not understand in the textbook by Dornbusch and Fischer.

But investors should realise that the accompaniment of continued high oil prices and stronger general inflation levels will be further weakness of the US dollar, as the derivatives issue will mean that supporting the banks necessitates low interest rates, while precious metals will have a boom like in the 1970s when silver reached an inflation-adjusted $120 and gold $2,200.

It is just possible that the Fed might try to raise rates a little to convince markets it is serious about defending the dollar but that would crash Wall Street like in 1974. And then interest rates would have to go even lower. Inflation is back and high oil prices are here to stay.

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