Some time ago I was one of many commentators pointing out that the price of oil on the spot market was above what even high demand should produce. The conclusion was that the "speculative premium" was caused by money gambling on commodities rather than investing in stocks. There isn't anything intrinsicly wrong with speculating on markets - I've advised people to do it. However, from the perspective of policy it is a problem, because it means that money is flowing to cushion a supply problem rather than solve a supply problem. One of the few good effects of the Reagan reduction in capital gains was to encourage money to flow out of commodities and into investing in stocks. However, more important was the reduction in excess liquidity pursued by the Federal Reserve and other central banks.

Hindsight confirms what energy bulls like myself were saying - that the price people are paying for commodities has to carry the weight of a world awash with liquidity on its back. It's hard to go upstairs lugging that kind of weight, and it makes plain the economic policy challenge going forward. Either create more investment supply to soak up investment demand, or accept that investment demand is going to continue to drive inflationary pressures, though in more volatile fashion than wage pull would.

Let me put this in other terms. Back in the 1970's, if you look at energy inflation, and inflation generally, it tends to follow a series of sharp shocks upward, and then a plateau. This is because the inflation of the 1970's was driven by the problem that liberal and socialist governments of that time threw gasoline on the fire of inflation - wages went up, people bought more oil, which both piled up a dollar glut, and reduced investment.

The blind spot was that for decades the Keynesian idea of increasing wages, and letting demand find its own supply stopped working. Instead there was the rise of schools of conservative economics that placed the emphasis on the behavior of the rich. This made sense at the time, because, if you look at it, the problem at that moment was that there was new group of rich people who wanted to play the game - namely the oil rich countries, which had elites that could output at industrial world profitability, without industrial work forces.

The reason Keynesian wage expansion worked so well is that the more developed an economy was, the more developed its demand for products were, and the more developed the workforce was. Better workers and better demand drover better products. This plus the military side of research was enough to keep the west ahead.

It wasn't, then, oil per se, that drove the problem, but a mismatch between political method and economic reality. The solution, in liberal terms, would have been to have very high interest rates, and cushion the blow with spending. Eventually, that is what happened, only it was a Republican President that did the spending. The poliltical coalition of those who spent on themselves and didn't pay enough in taxes to sustain that spending has continued to shrink, as the amount of money available to borrow and squander has shrunk. Reagan could buy a landslide, Bush could only borrow enough for a squeaker.

Both in economics, and in politics, the change in political method, in how economic policy was supposed to "feel" was more important than the changes in economic theory. It may be hersey to say it, but economics runs around trying to figure out how people rationalized what they just did.

One can see the difference in feel that in the difference between the way that liberal oriented economists call for a minimum wage hike, and the way conservative leaning Edmund Phelps, who was just awarded the Nobel Memorial for his work on unemployment darkly warns of counter cultures that focus on "being over doing". Solow signs a statement about helping people, Phelps seems to believe that wage slave jobs are good because it is cheaper than putting people in jail. The mathematics shows no such tone - inflationary employment mismatches are applicable to critique the present American reactionary policy (and indeed such mismatches are a driving factor in the downward real wage spiral), and just as Solow's growth theory can be used to critique attempts at protectionism. The differences are less in what the numbers say, and much more in how different voices put those numbers into words.

Which is why right now we are in an odd paradox, namely that we have a dominant party of the right which is busy smashing to small fragments the very economic policy regime that that same right wing party put into place.

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The problem we have is that there is a fundamental contradiction between our political method and political heuristics, and the policies which our own policy regime requires. The Keynesian era thought that if you gave consumers money, then it would create supply. The Friedman-Mundell economy believes that if you give investors money, then it will find its way into capital which will create supply to lower prices.

The Keynesian era ran into trouble when it could not figure out how to shift wages into investment, rather than consumption. The F-M economy had a simple solution - cut taxes on rich people, raise them on everyone else. That is exactly what happened. Income taxes, particularly capital gains taxes, which fall more heavily on the wealthy, were slashed - while payroll taxes, which fall more heavily on hourly wage earners, were raised. Less money in people's pockets meant less demand for basic consumption, including oil. The money flowing to rich people meant they could keep pace with Saudi royals and bid up the price of developed world assets with the richest of the oil archs. There, problem solved.

But a new problem created.

That new problem is that the people who voted for conservative government were people out in the hinterlands - that is, the people who flattening of the tax system and increases in payroll taxes didn't help much, in fact, it hurt them. This is because the hinterlands are involved in commodities production - oil, wheat, iron, copper. What financial types call "stuff". This contradiction played itself out in a Republican Party that had low taxes, and high spending.

At first there was enough built up US savings to keep this going for alot of people - Reagan and then Bush won two of the most overwhelming landslides in US history. From coast to coast, suburban voters voted against cities, black people, and higher wages. Since America was aging, a coalition of those who stood to lose more from the inflation tax than to gain from higher wages was politically viable.

However, in 1987 the catch showed up. Namely that in a true monetarist disinflationary monetary policy, there isn't enough money to float the top of the economy. The solution, for such it was, has led to Greenspan being called "the Maestro" and the mess that Greenspan made. Both are right. What the generation of conservative leadership, economic and political, had realized was that it was time to be conservative inflationists.

This may sound like a contradiction - but only because we are used to conservatives from the post-gold standard world, where were deflationists. Get ahead in the money game, and squeeze. Unfortunately in the late 1920's and early 1930's, the conservatives grabbed themselves by the balls and squeezed. The wave of conservatives in power now were determined to avoid that fate. It's not a coinicidence that Bernanke's academic work on the Great Depression involves finding a scenario by which Hoover could have kept monetary policy loose enough to avoid the worst of the downturn. No bank collapse, the reasoning on the right goes, no FDR.

Conservative inflationists have a simple policy game, keep the money from "trickling down". Basically, declare that inflation that isn't in wages, goods and services, isn't "really" inflation. This works as long as the people holding dollars will agree. Since the people holding dollars right now are Asian central banks, oil barrons and the wealthy who have banked dollars in the NASDAQ and New York Stock exchange, you might think that they would worry about asset inflation. But they are selling asset inflation - if what they own goes up in value, so much the better for them.

However, sooner or later, all bets on investment have to be paid by consumers. Since consumers haven't seen real wage increases in 30 years, the money to pay off the every increasing pile of bets on the future has to come from someplace.

Now if there were an unlimited amount of oil bandwidth and other basic materials, and there were no downsides to pumping carbon dioxide into the atmosphere, this would work. Eventually people who are poor now will be rich later, and they will buy more and more. Consumers in the developed world wouldn't have their standard of living go up much in real terms, but there are billions of people to sell cars, toasters, computers and so on too.

But, unfortunately for simply pumping ever more money into the system, there are resources whose bandwidth doesn't go up with the amount of money, and which upper class investment doesn't have much incentive to get around. Namely, oil and atmosphere. They aren't making any more of either in any quantity that matters.

At first the paradox of flat wages and ever greater appetite for profits was paid for by having wives go to work. Families that had put 40 hours of work in a week and 5 hours of commuting, started putting in 80 hours of work and 20 hours of commuting. However, that began to top off long ago, and has reverse itself. The second wave was to have the savings of the working class - that's everyone who makes most of their money from a paycheck, however, large - slashed. One way to slash it is to lower pensions and retirement health benefits. Social Security was cut twice - once by Reagan, once by Clinton. But even this is no longer enough - formal savings is also negative for bottom 99%, and has been for some time.

This is the weight of money - there is more and more money placed on the casino of what consumers are going to buy, and a limited amount of prosperity that can be generated in the current oil based economy. The reason gasoline went up so much wasn't supply disruption - but the money that was sitting on the table betting on higher gasoline prices.

Oil is now down to a few dollars above its demand price - the price we'd pay if there were no speculation going on. The current US slow down is likely to eat into oil prices a bit more, but already real supply constriction is coming into play. If Americans were of a mind they could start all over again at square one and constrict oil prices, and slowly force OPEC back over a barrel - where they were back in 1995. It would take 15 to 18 years. It would involve more reductions in real standard of living. It would involve at least one or two more long recessions, where it takes years to get back even to where we were before the recession. It would mean a continued rise in poverty, and more reliance on low wage outsourcing.

And there is no assurance it would even work - once upon a time, if the US decided to slow its consumer economy, everyone else just had to live with it. Now with the emergence of China and India, while the rest of the world wouldn't like a big US slow down, they could begin moving away from being dependent on the US consummer as the designated idiot of the world economic system.

The other solutions are to simply accept being poorer - which I doubt would go over well politically - or to find a way to expand the economy beyond the bandwidth of oil.

This second option is easier than people think, what is holding back the exploitation of non-carbon energy is very simple: there is still some very, very, very, very cheap carbon based energy out there. Imagine, however, there was no $6/barrel Saudi Light and Sweet. That is, if all energy were expensive, then there would be every incentive to move from extractive energy, to capital based energy. The reason we aren't doing so is that there is so much more money to be made betting on who will pay $70/barrel for something that cost $6/barrel. In otherwords, there is so much money sitting on old bets, that new ones are harder and harder to make. Other than computers, not much has changed about our physical culture in years. Peak oil could be a catastrophe, or it could be liberation. The choice is, in fact, in our hands.

Right now this means we should expect a period of speculative blow off in energy and commodity prices, as the short term down turn - which probably will not be a macro-recession under the new Bush friendly rules that the NBER is using - slows demand a bit. However, since Bernanke is going to keep money loose - much as the Federal reserve did through Nixon's term in office - we will be back off to the races before 12 months is out. The only thing that will have happened is that the consumers will have been shorn of what they thought was their "savings", just as their pensions and social security and medicare are being shaved to the scalp.

In the longer term however, a political coalition to back a new political methodology is growing. The Keynesian answer was "expand consumption demand", the Friedman-Mundell answer was "expand investment demand".

The new answer is "expand investment supply" - that is, increase the number of ways that people can form businesses that will pay the natural cost of money. Paradoxically, as is often the case in economics, this involves raising the price of something that is overconsumed because it is under-priced. If we had to pay for that fraction of our defense budget involved in keeping the Middle East from exploding into war with a gasoline tax, and pay for the costs of global warming, the gasoline would be about twice as expensive as it is. Since taxing gasoline on the front end is political suicide, the answer is to tax it on the back end.

Another method of this answer is "decrease information assymetry" - that is decrease the ability of some players to make money by withholding information. This is one of the reasons that the internet generation is moving left - pumping information into the system is what we do, not just for profit, but for fun.

Finally there is the most contentious piece, the one that is going to force the body politic to adopt a new kind of economic policy stance - namely if they don't the result is going to be protectionism. Even people like Bernanke can see this, even people like the negotiators for the Doha round can see it - the benefits of globalization must be spread out more, or people will slam the door shut on trade.

You see, the pendulum has swung completely from one side to the other. In 1980, the wealthy had been hammered by taxation, which wasn't an issue until money started pouring into OPEC nations, and didn't pour out again. Now it is the reverse - the wealthy are fat, very fat - but the people who are going to do the buying that will pay the profits that the value of all the world's stocks and bonds rely upon, are just about tapped out. Starting with Thatcher there was a revolt of the rich.

Very soon the pendulum is going to turn the other way, as people who work realize that what is holding them down, is the weight of money they carry on their backs. In another age Keynes called gold "that barbarous relic", which had the problem that there was no organic link between the growth of a technological economy and the monetary base. The weight of the gold standard capsized as the wars for control over resources bankrupted the nations that fought them.

Now the weight of oil based money is doing the same thing, even the relatively small war of Iraq is bankrupting the United States. Bush can use all the funny money accounting he wants to say that the "deficit has been cut in half", but this is only by shoving hundreds of millions off budget - both by spending the Social Security revenues that, in theory, need to be paid back, and by the fiction of having the Iraq War and Afghanistan War being off budget.

You see, carbon is a rock, and most of it should be in the ground. And the 21st century is no time to have money based on rocks - which means that soon the call is going to go out to drop our barbarous relic, and enter into the age of capital energy, and capital based money.