Sunday, December 2, 2007

Another Decade of Dependence

I was reading the Wall Street Journal Online Edition today and came across an article Sovereign Impunity (subscription may be required). The article points out that the Abu Dhabi fund that just purchased a stake in Citigroup (a convertible preferred that converts to approximately 4.9% of the company’s shares) is funded with oil dollars. This fund now controls an estimated $875 billion according to this article, which is approximately 25% of all of the $2-3 trillion of assets owned by all of the sovereign wealth funds. This is an entity that obtains its funding through the sale of oil which is controlled by the government, not through free market risk taking. The article concludes by stating that it is US monetary policy that is responsible for the growth of these funds:

These funds owe much of their current size from bad U.S. monetary policy. We were nearly as ‘dependent on foreign oil’ in the 1980s and 1990s as we are today. But with a responsible Federal Reserve and strong dollar, there was no boom in petrodollars.

Only in this decade, amid the Fed's dollar abdication, have we again seen the boom in commodity prices that is enriching Russia, the Arab kingdoms, Venezuela (read a related Review & Outlook) and other dubious corners of the globe. Our own monetary mistakes have made these funds richer than they would be under normal market conditions. The response should not be to restrict their investment, but to start protecting the value of the dollar so that the price of oil falls back down to where it reflects supply and demand, not a cheapening U.S. currency.

Now, I may agree that our monetary policy has contributed to the decline in dollar value, but this completely misses the point. Before even considering the real issue, however, I point out that without a declining dollar we never get to a balance of trade that we can sustain over the long term. That said, what is the real issue?

The real issue is energy independence and it has been energy independence since the very first oil shocks in the 1970s. I knew this even as a teenager waiting on line at the gas station to put gas in my car. When we were originally impacted by the oil shocks we learned that we have an issue that must be dealt with in the long term, and that issue is that we are dependent upon foreign resources for our energy needs. As we have supported globalization through our trade policies, we have also increased competition for these foreign supplies from the emerging economies we support, making us even more vulnerable. This is not the 1980s or even the 1990s, and we now have serious global competition for scarce resources. Finally, we are learning that we cannot continue to poor pollutants into our atmosphere without consequence, and burning more fossil fuel is probably a bad idea.

Just how dependent are we on foreign oil? Well, according to the Energy Information Administration, in 2006 we imported on average 12,390,000 barrels of petroleum products per day. Based on a price of $94 per barrel, that’s about $1,164,660,000 ($1.16 billion). So what is today’s value of 4.9% of Citigroup in terms of petroleum imports? It’s about ($7.5/$1.164) 6.5 days of imports. That’s right, 6.5 days of petroleum imports equals 4.9% of Citigroup in today’s market. (I note that prices of different petroleum products differ, and the price changes regularly.)

Is this a result of poor monetary policy? I argue it is not, and the same forces that have driven up the price of oil have driven monetary policy. These factors are primarily related to globalization and our reaction, as a country, to it. For one thing, we have relentlessly pursued the pools of lowest cost labor we can find. This has driven prices of imported goods down at the same time we have made tremendous productivity gains. These forces have placed downward pressure on prices, and even threatened us with deflation in the early part of this decade. (Unfortunately none of this applies to health care or education that, for now, require the actual presence of professionals.) In response, the Federal Reserve lowered interest rates according to its traditional mandate so as to maintain growth and price stability. In this case, price stability meant avoiding deflation so the reaction was to keep interest rates extremely low for a long period of time. The natural result of this action is an increase in the money supply and a decrease in the value of the dollar (as well as pricing bubbles in, say, real estate). Ultimately, then, our pursuit of cheap labor comes back to us in the form of higher import prices due to a falling US dollar and asset bubbles. A side effect of this policy is that with a declining dollar the dollar value of our raw material imports increase. Add to that scenario the fact that we are now competing with countries such as China for the raw materials to be found around the globe, and we see why the prices of oil and other raw materials are rising. To blame monetary policy for this is to say that we should have left interest rates higher in the early part of this decade and likely suffered a recession with a simultaneous deflation, something that could be devastating to any economy. So is monetary policy responsible or is it the overall trading policies of the United States? I don’t believe the monetary policy argument is the critical issue.

(For additional reading on the impact of higher oil prices on monetary policy and the economy, there is a good article here at the Federal Reserve Bank of San Francisco website.)

Now that we can at least question whether it is monetary policy that is responsible for rising prices or some other factors that resulted in our monetary policy, we can move to the true cause of our problem. Despite decades of advance warning, we have not pursued, together as a nation, alternative sources of energy. Surely this is a goal that almost every American supports, barring those whose livelihood flows from the vertical chain of the oil industry. Lets take a look at some estimated numbers.

If we take the daily barrels we import and convert that to an annual amount, we get 148,320,000 barrels per year. Multiplying that by $94 per barrel gives us an annual cost of about $424 billion. How much is $424 billion? To put it in perspective, it is over two times the projected 2007 fiscal budget deficit of The United States, and on a monthly basis over 60% of the $56.5 billion total US trade deficit in September 2007.

Of course, finding alternative sources of energy is not free, and the alternative energy itself will not be free (although some sources may turn out to be just that). What it would be is liberating for the United States and other oil importing countries around the globe, and possibly very profitable and stimulating to our economy. So, rather than pointing fingers at who or what is responsible for the current situation that leads to 6.5 days of oil imports = 4.9% of Citigroup and proposing ways to make oil cheaper (not that I have a problem with that), I believe we are ready for the national challenge similar to the Kennedy era challenge of reaching the moon. We should have been ready for it decades ago, but we were lulled into complicity by low oil prices. Think of the change in policies that could result from energy independence. Would we fight as many wars? Would the world fight as many wars? Would we be wealthier? Would we save the earth from global warming? Could achieving energy independence balance the budget? Provide for Medicare? Decrease our defense spending? Etc.

I am certainly not the only person advancing this issue these days, but I feel strongly that more people need to advance it and be heard. Certainly a goal of energy independence through alternative and environmentally friendly sources is worth our consideration, our investment, and our short-term sacrifice. Should this be left to the free markets or should we look at this like a system of highways – something we need to build together, combining public finance and the free market system in order to foster the ability of free markets to further our advancement in the annals of human history? I believe the latter, and hope that even if oil prices fall substantially, we have learned our lesson and will make the necessary investments. At this point in our national history I crave a positive issue to unite around. This sounds like a timely one to me. Of course, that’s just my opinion.

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Anonymous said...

Right on, Mark. Keep trying, maybe enough people will listen at some point.

Of course, by then it might well be too late, but ya gotta try.

Palermo's Blog said...

Thanks dark1p. Spread the word!

Lawrence D. Loeb said...


One problem with reading, as opposed to the print version, is that they don't always make clear what is an "article" presenting facts and what is opinion. Page A12 on Saturday was the opinion section, and the item you quoted from was an editorial.

The Wall Street Journal is a good paper, but their editorial page can read like a comic book sometimes.

The current oil prices are only nominally related to a weaker Dollar. The main reason that oil is priced so highly is that demand has increased (largely due to the belated industrialization of India and China). Since oil is priced in Dollars (there is a risk component, just look at long term oil prices), and the Dollar has lost value against other currencies, oil would be cheaper in Dollars if the Dollar was stronger.

While the Journal seems to always be in favor of a strong Dollar (almost equating it to apple pie and baseball), they don't really make a good case for it.

Currencies fluctuate. This is partly driven by trade and partly by capital flows.

We have been running a trade deficit for quite some time. The Dollar was kept high by capital flows (or the absence of capital outflows). As the Dollar declines, US products become cheaper in other markets and imports become more expensive. Eventually the cycle typically reverses.

If the Dollar was stronger, unemployment would probably be up and the economy would be slowing. Higher interest rates would aggravate the current capital markets problems.

Using oil prices to beat up the Fed shows a lack of understanding of basic economics. Guess that's why they're journalists.

Your point about the need for alternative fuels is right on.

Good post.