Black gold: the end of Bretton Woods and the oil-price shocks of the 1970s.

• Author: Hammes, David

The U.S. dollar price for a barrel of oil rose from $3.35 in January 1970 to $32.50 by the end of the 1970s. On a single day, January 1, 1974, the Organization of Petroleum Exporting Countries (OPEC) raised the U.S. dollar price of oil a staggering 135 percent, from $4.31 to $10.11. (1) Few would disagree that OPEC's action was one of the most important events of the 1970s--so important, in fact, that even current U.S. high school students are generally aware of it. Virtually all economists, ourselves included, agree that it had a major impact on the world economy. A huge price rise in such an important commodity certainly had a tremendous allocative effect, and many economists also interpret it as having a causal effect on U.S. price inflation. (2) Whether it caused U.S. price inflation, either directly via cost-push or indirectly via monetary accommodation, is still being debated, but the rise in the price of oil remains central to the arguments. (3) We do not enter that debate here.

The standard explanation of OPEC's ability to implement such a dramatic price increase is that its members composed an effective cartel, and, motivated by a cluster of political events and nationalizations of oil facilities, they used their cartel power to extract more monopoly rents from the West. However, this interpretation is not the only way to model OPEC's behavior. (4) In this article, we make no attempt to provide yet another model to explain OPEC's behavior.

Independently of how OPEC's behavior is modeled, implicit in all the analyses we have seen is the assumption that the appropriate index to compute the real price of oil is a U.S. price index, such as the Consumer Price Index (CPI). Our purpose here is to challenge and to modify that assumption.

The microeconomic cartel model, for example, implicitly assumes that both the buyer and the seller are using the same currency with a constant price level. Therefore, both sides agree on the real price. Given the change in institutional environment that took place in the early 1970s--namely, the end of the Bretton Woods Agreement--the naive application of the cartel model, among others, is inappropriate to analyze the OPEC price increase and, without some adjustment, may be fundamentally misleading. We are not offering here a historical-revisionist argument that the price rise never really happened--we recognize that OPEC really did increase the U.S. dollar price of oil by more than 800 percent in the 1970s. Nor do we attempt to explain how OPEC arrived at its pricing decisions. We have a modest goal: to examine, in a world of flexible exchange rates and institutional change, whether that more than 800 percent increase in the U.S. dollar price of oil entailed that the real price of oil received by OPEC members increased by more than 800 percent.

The 1970s

During the 1970s, the U.S. price level, measured by the CPI, rose by 106 percent. The U.S. dollar price of oil rose by 870 percent. Therefore, the real price of oil from the perspective of American purchasers actually rose by approximately 370 percent. This increase was a dramatic change given that the real price of oil had fallen by 20 percent during the previous twenty years.

The foregoing view, however, is entirely from the perspective of U.S. demanders of oil. When analysts apply the cartel analysis to OPEC behavior, they are making the simplifying assumption that both the buyer and the seller are using the same currency and agree on the price level. This simplifying assumption would be relatively harmless in a world of fixed exchange rates, especially if rates were tied to a commodity, such as gold. Under such a system, changes in the price measured by one currency are easily mapped onto changes in prices measured by other currencies or to the price of the base commodity. Therefore, it is reasonable to assume that both parties are using the same currency and agree on changes in the price level.

This simplifying assumption is not harmless, however, when we are analyzing the OPEC price increase of January 1, 1974, because, commencing on August 15, 1971, the Bretton Woods system of fixed exchange rates collapsed, giving way to flexible exchange rates and a rapidly evolving institutional setting.

To appreciate the impact of this institutional change, consider how the world looked during this time from the perspective of sellers of oil who made the bulk of their sales to Western countries and Japan. With the proceeds of their sales, sellers purchased goods and services from the advanced industrial countries (and others) and made investments. In 1970, oil contracts were stipulated in U.S. dollars, and all currencies were fixed in relation to the U.S. dollar and in relation to gold (because the dollar itself was fixed at $35 per ounce of gold). With low inflation and fixed (or relatively stable) relationships between the currencies, the real price of goods could be computed easily regardless of where they were purchased. Therefore, the currency or commodity in which the price of oil was quoted made relatively little difference. Prior to World War II, oil contracts had been quoted in terms of gold or pounds sterling. If that practice had continued into the early 1970s, little would have changed for either purchasers or sellers of oil.

The collapse of Bretton Woods and the end of the fixed price of gold in 1971 changed the situation substantially. As OPEC quickly learned, the currency or commodity in which the price of oil was quoted did matter now. If contracts had been stipulated in pounds sterling, then in October 1973 OPEC would have received from U.S. customers $4.32 per barrel (versus $4.31, the quoted price at that time). The prices are virtually identical because the U.S./U.K. exchange rate had not changed. However, if contracts had been stipulated in Yen, OPEC would have received from U.S. customers $5.82 per barrel (versus $4.31). And if contracts had been stipulated in gold, by October 1973 OPEC would have received $11.83 per barrel from U.S. buyers. Note that this latter price is $1.62 more than the price OPEC charged after the price "increase" that they instituted three months later.

Prior to 1974 the real price of oil to OPEC countries had been falling in terms of nearly all Western currencies and especially in terms of gold (and virtually every other commodity on the world market)--and this...