May 2008
American consumers, I am sure, would love to drive now and pay for gasoline later. John McCain and Hillary Clinton are promising them exactly that: a federal gas tax holiday this summer. This has to be one of the dumbest things I have heard so far in this election campaign.
The Federal Government is currently running a deficit, spending more money than it receives in taxes. If the government now foregoes gasoline tax revenues, this deficit will grow at an even greater rate. Every dollar the government does not receive in gasoline taxes will have to come either from other taxes, or from increased borrowing. If the government gets the money from other taxes then consumers did not get a break at all, they just paid in other ways. If the government borrows more money to make up for the missing gasoline tax revenues, the American people’s total liability will increase while they drive on credit this summer. But at some point this liability will have to be paid.
Yet these are not the only flaws in this gas tax holiday proposal. Left alone, markets have a way of dealing with price changes and their underlying causes. Rising prices force consumers to ration their consumption, leading to a decrease in demand and ultimately either falling prices or stabilizing prices. If Hillary or McCain were president and did manage to temporarily reduce the gasoline price by foregoing the federal gas tax, it would artificially stimulate consumption of gasoline thereby increasing demand and exacerbating whatever is causing the price to rise in the first place. Yet this simple economic principle is completely lost on both presidential candidates.
But Hillary wouldn’t stop there. She proposes that big oil companies pay the federal gasoline taxes instead of consumers, since these companies are making so much profit lately. This would be on top of the royalties and income taxes they are already paying. She supports this proposal by stating that the oil price must be manipulated and therefore the “windfall profits” that oil companies are receiving should be seized by government.
Let’s look at the use of profits. Regardless of why the oil price increased, the increase in price suggests that there is substantial demand for oil. It would make sense then to try and stimulate the discovery and production of more oil, so that the supply will increase and mitigate the effect that demand is having on the price. These “windfall profits” are precisely what is needed to help the situation: oil companies will use the money to boost their search for new oil deposits, and bring more marginal oil wells into production thereby alleviating the rise in the oil price with increased supply. What Hillary wants to do is take this ability away from the oil companies and, instead, spend it on whatever pet projects she can dream up to please some voter, somewhere. Such senseless pandering is precisely what causes immense misallocations of capital and leads to waste and loss of productivity.
Now, let’s look at the manipulation of the oil price. Hillary is adamant that the oil price must be manipulated or it would not be so high. Being past peak oil immediately comes to mind, but for our purposes let’s assume that whether or not we are past peak oil there is sufficient oil right now, today, to meet immediate demand.
OPEC states with regular monotony that the increase in the oil price is not due to lack of supply, which is at odds with Clinton, and others, who advocate suing OPEC. Hillary says that an Exxon executive testified under oath before a House of Representatives committee that the oil price should be about $50 to $55 a barrel based on market forces. From this she concluded that the oil price must be manipulated. In fact, there is some truth to both statements.
If we look at the exchange rate of the US dollar against the euro, and the twelve currencies that comprise the euro before its launch, we see that in January 1970 it took 1.151 “euros” to buy a dollar. Today it takes 0.644 euros to buy a dollar. For the sake of simplicity let’s use the euro-dollar exchange rate as a benchmark for the dollar’s devaluation on foreign exchange markets. From this exchange rate we can see that the oil price would have been 44% lower today were it not for the decline of the US dollar exchange rate. That would make the oil price, not $120 a barrel, but only $67 a barrel. $67 is still more than $50, or $55, but it’s close enough to show that the oil price is approximately 80% higher today than it would have been if the government was not so hell-bent on destroying the dollar.
This leads to our second conclusion: Hillary Clinton is also correct in suspecting market manipulation, but it is not the oil price that is being manipulated, but the dollar itself. By increasing the supply of dollars the government devalues every dollar in existence by an equivalent amount. The impact of this inflation is not uniform through the economy or markets but, with time, it does filter through to everything. If we look at the price of oil in US dollars and simultaneously look at the inflation of the dollar we can see that oil has in fact not gone up in value at all – it is the dollar that has declined in value. So the manipulation is clearly evident, but it is not the supply of oil that is being manipulated, but the supply of dollars, to decrease the dollar’s value on the assumption that that would stimulate spending and economic activity. That is the cause of the rise in the oil price.
For those who cannot fathom that it’s as simple as this, or that inflation of the money supply directly affects the value of the dollar, consider these words from Ben Bernanke, the current Chairman of the Board of Governors of the Federal Reserve Bank of the United States, in a speech he made on November 21, 2002 before the National Economists Club in Washington, D.C.: “Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.”
Aside from the fact that the assumption that inflation can create economic activity is entirely false, the idea that OPEC is somehow to blame for the rise in the oil price is absurd. Look at the chart below that shows the oil price in US dollars and the increase in the supply of dollars as measured by M3. We see that the oil price is trying desperately to catch up with the dollar’s inflation. In fact, if anything, oil companies and oil producers have been subsidizing American gasoline consumers for the past 22 years!
The manipulation is clearly in the dollar. By rapidly increasing the money supply and thereby decreasing the value of the dollar the government is directly and solely responsible for the increase in the oil price. If Hillary, McCain or Obama had any sense of responsibility they would tackle this issue first and foremost, since inflation of the money supply is also the primary reason for the increase in the wealth gap -- it hurts people with lower incomes far more than high-income earners, or those with a high net worth (see “
Why the wealth gap keeps growing”, November 17, 2006, reprinted below).
Another way to look at the same data is to adjust the oil price for inflation, by dividing the oil price by the increase in the supply of dollars (M3), as I’ve shown in the chart below.
Now you can see that while the oil price is certainly not constant, there has been very little in the way of a real (inflation adjusted) increase in the price of oil since 1959, aside from the spike in the oil price during the dollar crisis of 1979 and 1980. In fact, on an inflation adjusted basis, the oil price is lower today than it was in 1959. From this chart we can again clearly see that it is not OPEC, or the oil companies, that are to blame for the rising price of oil, but the government’s irresponsible inflation of the money supply.
On another front, a proposal was tabled in the Senate this week to mandate higher cash collateral for energy futures trading. The thought is that since energy speculators must be responsible for driving up the price of oil, the government should increase the cost of such trading, thereby making it harder for energy speculators to engage in futures transactions.
This proposal again demonstrates the complete lack of any fundamental understanding of how a market works, and will have exactly the opposite effect to what its proponents have in mind. Professional speculators are seldom the cause of unjustified price increases or decreases (although they can be). Quite the contrary -- if speculators deem prices too low they will buy a commodity thereby preventing prices from falling further. Similarly, if they deem prices too high they will engage in short sales thereby mitigating price spikes. The end result is less volatility, not more volatility. Financial speculators are usually very well informed and intelligent people, and they risk their own capital or capital entrusted to them. They look at markets and assess the potential real return on capital before they attempt a trade, and therefore as a whole are unlikely to take unnecessary risks or do stupid things -- unlike ignorant bureaucrats who every so often feel the need to pacify voters with more senseless regulation.
Now, I am not going to try and argue that speculators as a group are always right, or that they do not sometimes get carried away and drive prices too high or too low -- they are still human. But when speculators make such serious mistakes they typically lose their own capital, or the capital entrusted to them, and so the market eliminates them or, at least, “educates” them to make better decisions in the future. However, taken over a longer period of time and across a spectrum of commodities, speculators as a group undoubtedly reduce volatility in prices. In the rare instances when speculators do drive prices far too high, or too low, it is usually the result of unsophisticated “retail” gamblers trying to get rich quick at the end of a market cycle.
In the case of oil, the incredible inflation rate of the US dollar, as measured by M3, is clearly devaluing the currency and causing the oil price, and many other commodity prices, to soar. By making it more expensive and difficult for speculators to participate in the market, legislators will achieve only an increase in price volatility and the loss of market share to foreign exchanges that do not impede speculators from doing their work.
Notwithstanding anything said thus far, the oil price had a good run and so in the short term a pull back in the price of oil should be expected. But this would merely be normal market volatility, as we are currently seeing in the gold price. Over the long term the price of oil is going up. The days of $50 or $55 oil are gone forever.
The only thing sadder than the general lack of understanding of basic economics among politicians is the severe lack of knowledge among the voting population that compels them to vote, time and again, for candidates and policies that ensure the deterioration of their living standards while simultaneously sacrificing their civil liberties “in the name of freedom”.
