Wednesday, August 31, 2005

Rising oil costs: still nothing to worry about

The following is adapted from what I sent to the Life, Liberty, Property blog community mailing list. It's in response to Anarchangel's entry A New Hostage Crisis.

I've written a couple of blog entries on oil prices. Since I commute via train from Westchester to Manhattan, I haven't been to the pump in two weeks. But even if I drove regularly, I wouldn't be worried about the overall American economy.

Nobody can afford "high-priced" gasoline?

What to do about the price of oil?

There is indeed a lot of market pessimism about both crude and gasoline supplies, and I expect prices to settle back down in a few months. Now, even at "catastrophic" prices, rationality will have to set in sometime. Speculators will eventually realize that they've pushed prices higher than what is worthwhile to them, and the market will correct itself naturally. It's very much a two-edged sword: those banking on higher oil prices, and so far successfully, have that much further to fall. Every generation seems to need such a lesson.

Chinese and Indian demand will keep prices higher for the foreseeable future, not likely at current levels, but higher than we were accustomed to until a couple of years ago. After all, China's demand for oil has doubled in the last decade. But the Chinese are very smart, investing in Albertan tar-sand operations as well as offering to buy PetroKazakhstan (Canadian-owned). I talked about that here (and why China looking out for its oil interests will benefit the United States).

The greatest panic would still not be a problem, because the price system will do what it's supposed to do: allocate oil and gasoline (or any resource) to whoever values them the most. Say that gasoline hit $4 per gallon, prompting me to cancel plans to drive upstate for the weekend. That means more diesel (since there will be more crude available to be refined into diesel instead of gasoline) is available for trucking companies who do value it at $4. Meanwhile the higher prices will encourage oil companies to find new sources of oil that were previously not feasible. Both will push prices back down to an equilibrium point. Now let's apply this to the global market for crude. "Lemming speculators" might be following the hype, and they might just be paying higher than they ought to. Nonetheless, they're willing to pay a premium to ensure their share of the market, and by definition they still can afford to pay the higher prices. It's not inherently a bad thing.

Americans have already been purchasing more fuel-efficient vehicles while cutting back on unnecessary driving, and they're even learning to slow down on the freeway (trading fuel for time). If oil got really high, more will start carpooling. So the price of gasoline may be increasing, but Americans are cutting back on their individual gasoline usage, so their individual fuel costs are increasing at a slower rate. Ah yes, let's not forget heating oil: many here in the northeast will keep the thermometer down a degree or two during the upcoming winter. They hope not to pay too much than before, which leaves more oil available for others who value it more. See how the price system forces conservation far more effectively than any legislation (let alone environmentalist campaign)? It's true you'll pay a higher price to use a scarce resource, but the point is that you won't run out of it.

Regarding the risk of a recession, that's extremely doubtful even at $70. Macroblog noted this April that one-third of economists in a summer 2004 WSJ survey thought the U.S. would suffer a recession if crude stayed between $50 to $59 per barrel. In the newest survey at the time, a total of 79% of surveyed economists said crude would have to sustain a value higher than $80 [to cause a recession]. But I question whether they've fully accounted for the incentive factor: again, if gasoline gets that high, people will cut back on their purchases of it, which will temper prices. After all, the old joke goes, "Economists have successfully forecasted ten of the last three recessions." Look to Paul Krugman as the ultimate false prophet of economic Armageddons.

It's not the end of the world (actually far from it) to spend a higher percentage of your income on fuel. It's a shift in spending, not a reduction. It might appear that you have less to spend on other things, but don't forget what happens to the dollars that oil companies receive: they circulate through the economy just like everything else. Even if it's oil company executives making millions, they either have to save or spend the money like everyone else. And oil companies and OPEC aren't fools, either. Like any good capitalist, they're already investing some of those profits in expanding oil production (which again means you might pay a higher price, but you'll have all the gasoline you want at that price). After all, they can't let prices get too high, because that makes substitutes too competitive.

Contrary to conventional wisdom, it's far preferable that oil companies make a killing than for government to institute price controls. High prices encourage production and are not as large a hit to GDP as price controls. Price controls, on the other hand, discourage oil companies from producing as much oil. If crude may sell for no higher than $40 per barrel, or gasoline no higher than $1.50 per gallon, then oil producers will produce sporadically, if at all, because there would be only so much oil and gasoline worth selling at those prices. That means people get thrown out of work.

What about OPEC getting all the money? Well, foreigners aren't just going to stuff dollars under a mattress. Dollars eventually come back to the U.S., either in outright spending or foreigners investing in U.S. assets. Much of the new luxury housing in New York City is going to foreigners who are paying cash. This means jobs for American construction workers and real estate brokers, so how is it a bad thing? My aunt and her friends in real estate never could figure out where the foreigners got the money, but it's simple. They earned a lot through the so-called "trade deficit" that we've had for years, whether with Japan, China or Saudi Arabia. So we haven't exported wealth at all; quite the contrary. The dollars come home in one way or another, whether foreign direct investment, foreigners buying U.S. and corporate bonds, and U.S. real estate.

While it's beyond the scope of discussing oil prices, some of you may be interested in my entry about foreigners buying housing.

The concerns about OPEC is an expansion of something Caroline Baum once wrote. This is a must-read article, where she explained why higher oil prices are not a tax.

Since oil is so widely used in the U.S. economy, it's said to have a "ripple effect" and cause the price of everything to go up. Well, the Fed can help cushion that impact by tighter monetary policy (additional interest rate increases and/or slower dollar creation). I have severe misgivings about central banking, but as long as we have the Fed, we do have the power to use monetarism. The danger is that the Fed does too much (by overestimating the impact of higher oil prices) and thereby causes deflation.

Bush's decision to loan out some of the Strategic Petroleum Reserve will help cool crude prices, but it will likely have less of an effect on gasoline prices. Remember that the current relative scarcity of gasoline (in strict economic terms it's not a shortage) was already as much, if not more, of a problem with refineries than with crude supply. Even then, leave it to the price system to settle things out.

Above all, keep a cool head and don't believe the false prophets who predict Armageddon year after year. Thou shalt not fear the economic girlie-men!


Blogger Chris Byrne said...

Perry, as I said in response to comments on my post, I'm not concerned about the objective factors. What I'm concerned about is the psychology of the market, especially as influenced by the media.

If the objective factors were ruling the market right now, we would see an oil price around $50 or thereabouts. Clearly the current inflation is a result of rampant speculation (as I pointed in my post).

What worries me is a combination of panic buying, and the possiblity of further disruption in supply. This could result in a sudden panic.

Would it be jsutified by ojective factors? No of course not; but neither was the depth and length of the '29-41 depression.

Your fundamental assumption is that sanity will prevail, mine is that sanity is barely holding right now, and one more major incident will be enough to cause panic.

If that panic doesnt occur, than I'm 100% with you; in fact possibly more optimistic.

Thursday, September 01, 2005 5:47:00 PM  
Blogger Perry Eidelbus said...

Don't take this badly, but in referring to "objective factors," you fall into a trap well over two centuries old. In a free market system, there's no such thing as objectivity. It took Austrian economics, with its subjective theory of value, to save us from the erroneous "labor theory of value" (and similar concepts about price being determined by what goes into it) that Adam Smith, David Ricardo and Karl Max put forth.

People paid $20, $30 and $40 per barrel of crude because at those times, that's what they believed it was worth. They pay ~$70 today because that's what they believe it's worth. What anyone else thinks is irrelevant. Standing on the sidelines, we might think we're being objective, but actually we're as subjective as anyone else. We don't have the specific knowledge of time and place that oil buyers do (a concept of knowledge that Hayek developed), thus we don't know their motivations -- regardless of any speculation -- in paying what we think is "too high" a price. They have to stay in business, and if they pay $70 per barrel of oil, by definition they can pay, and they consider it worth paying so that their companies can keep operating.

No matter how rampant the speculation, don't worry: there is a price ceiling above which buyers cannot afford to buy oil. Successful buying requires the willingness and ability to pay what the supplier asks. Even if you monopolized a particular resource and limited its supply so you could charge supposedly whatever you wanted, that must give way to reality: you can't charge above how much your buyers value it and can afford to pay. And as the price of crude rises, that opens up many new sources of oil (and its substitutes) that previously weren't worthwhile. This will stabilize prices.

The best thing to do with the risk of further supply disruptions is to let prices keep rising. Yes, that's a serious statement, and it's very true. High prices will force people to conserve a resource that is suddenly scarce. High prices are how society doesn't waste a lot of time (i.e. incur large search costs) searching for a resource that is underpriced. However, I will agree to loaning crude from the SPR for two reasons. In filling it up, the federal government "crowded out" private buyers, because federal demand raised the price of crude. Second, the federal government is not selling, but loaning it at interest. So anyone "borrowing" from the SRP, by definition, is banking on lower oil prices in the future, or that if oil prices get even higher, it's worth keeping the firm operating.

And by the way, Austrian economics is the only discipline whose business cycle theory explains not just the Depression but every recession. Keynesian economics can't; Milton Friedman's monetarism explains the Depression but not every recession. Basically the Great Depression was like every other economic downturn, with overexuberant businesses overproducing for overestimated demand. Thus an economic downturn is a necessary thing to correct these errors.

It sounds harsh, but Austrian economics is "practical" in that if something is overextended, it should be allowed to (or even fail). Also, remember that while the Depression was inevitable, Federal Reserve policies in the late 1920s triggered the Depression to a far worse state than it should have been. The Depression also wouldn't have lasted as long had the federal government not tried to fix it, not just through massive "public works" spending and high tax rates that stifled business investment and destroyed companies, but by tragedies like Hawley-Smoot and farm subsidies.

Thursday, September 01, 2005 9:04:00 PM  
Blogger Chris Byrne said...

I'm not a BIG Von Mises fan, but in comparison to Keynes and his ilk he is the god emperor of the universe.

By objective factors I mean the ecatual basic economic demand absent psycholigically fueled speculation. Others have referred to this as natural pricing or demand pricing what have you.

I don't believe in inhernet value economics (down that road lies monetarism and advocacy of specie currency.. bad bad bad); something is worth whatever osmeone is willing to exchange for it, and at the moment we are willing to echange $3.25 or so for a gallon of gasoline.

I am trying to make the point that I beleive the potential for panic has nothing to do with the economics of the situation, but in peoples irrational psychology. You keep falling back to saying rationality will rule, and I'm saying it wont.

Perhaps you jsut have more faith in humanity than I do.

Thursday, September 01, 2005 11:33:00 PM  
Blogger Perry Eidelbus said...

Mises taught us how prices really work, and he and the rest of the Austrians taught us that value is all subjective. There's simply no way for anyone to make a fully objective decision as to an object's value, because you cannot extract, as you term it, the psychology. It's better described as each individual's particular knowledge of time and place, which are critical to each individual's particular actions.

Economics does include psychology, because it's fundamentally the science of human choices and their consequences. On the whole, people do make decisions rationally. Are you going to pay $2 for a single banana? If I have no knowledge of your circumstances, I'd probably say, "No, that seems a bit high." Yet if you're sufficiently hungry and have sufficient money (a condition I am not necessarily privy to), you will agree to that exchange.

Walter Williams once said, "Only unreasonable people pay unreasonable prices." People wouldn't be willing to pay $70 per barrel of oil unless they believed they gained from the exchange, i.e. that the barrel of oil is worth at least a little more than $70. It's perhaps fueled by false information or a false conclusion, but the decision itself is still rational.

Friday, September 02, 2005 12:10:00 AM  

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