Gas prices are one of the great mysteries of life. Pundits blame a few handy targets for rising prices: greedy oil companies, oil speculators, geopolitical volatility in oil-producing areas. But no one knows who to thank for falling gas prices -- nor how long they will last.
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That, says Â鶹´«Ã½AV Chief Economist Dennis Jacobe, is exactly the problem. There's a lot of finger pointing going on by people looking for an easy answer or a handy scapegoat. But in reality, the world markets are much more complicated. There are many myths associated with international trade and many national trade laws and subsidies that further confuse the issue.
But the effects of the disparate aspects of the global economy are clear: As the cost of oil goes up, the value of commodities rises too -- though perhaps not their real value. Various nations respond by providing energy subsidies, mitigating a potential drop in demand but distorting the price of products they produce. Energy price collusion, energy subsidies, currency artificialities, and shifting hedge fund sentiment further distort the price of almost everything in the global economy. As a result, consumers could be paying an inadvertent oil tax with every new T-shirt they bring home. All this, combined with the way the current global financial debacle is wiping out investments all over the world, is suspending the traditional rules of economic analysis and creating many unintended consequences. Dr. Jacobe, in fact, calls the whole situation "economically bizarre."
To help make sense of this, Dr. Jacobe unravels the tangled knot that leads from surging oil prices to oil subsidies to distorted prices to recession and back to a drop in prices, explains the effect of the value of the dollar on the U.S. economy, explains what all this means for consumers, and talks about what the new president and Congress need to do to improve the situation.
GMJ: I recently spent as much on gas in one month as I did on my first car. Then this month, gas is cheaper than milk. What's happening?
Dr. Jacobe: No one fully understands why these things are happening. One fundamental economic factor underlying the rise in gas prices is the growth of something approaching a middle class in emerging economies such as those of China and India. This new middle class is putting demands on food and energy supplies in ways that they weren't before. Further, emerging economies tend to use energy less efficiently than more developed ones, so their businesses and people use relatively more oil and other types of energy in their production process than those in the West. They're using more of everything. And the growth rate is phenomenal.
GMJ: So gas and food prices are going up because demand is higher in emerging economies?
Dr. Jacobe: That's one factor. But I also feel there are a lot of price distortions in the equation, and these are creating all kinds of unintended consequences for consumers and businesses worldwide.
GMJ: What are the price distortions?
Dr. Jacobe: People make a lot of assumptions about the global economy. When Americans talk about a "free market," they tend to think in terms of the U.S. economy. There are well-established rules of interaction in the United States; there are laws and regulations about competition, contracts, working conditions, safety, property rights, and all those kind of things. There is also legal recourse when people break the rules.
But the world economy doesn't necessarily act in the same way. There's no one set of standards that is applicable and effectively enforced across all countries in the global economy. Differing rules in terms of price collusion, governmental participation, financial supervision and regulation, and currency valuation, just to name a few, have a tendency to create considerable artificiality in global pricing.
GMJ: So gas prices are partly driven by a lack of global standards?
Dr. Jacobe: That's right. When you buy an imported item, the price might not actually reflect a "free market" price. For example, suppose that a country is artificially holding down the price of oil by providing subsidies to consumers and businesses within its borders. Therefore, businesses operating within the country can produce and sell goods that don't reflect the "real" price of oil on the global markets. And when the price of oil surges, these businesses may well be insulated to a large degree from the real impact of higher oil prices. Because the cost of a key input in the production of these goods is distorted, the price of the goods these businesses sell into the global economy is also likely to be distorted and not fully reflect surging oil prices.
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At the same time, the country that is subsidizing oil for its consumers and businesses may also be demanding huge amounts of oil on the world market because the internal demand for oil is insulated from surging prices. When prices go up quickly, people demand less of the product, and surging prices reduce or destroy demand -- people in the markets have taken to calling this "demand destruction" -- but subsidies moderate this effect. In turn, this lack of so-called "demand destruction" in various countries drives up the price of oil worldwide.
The end result is that everybody who uses oil -- and really all forms of energy -- is paying a higher price because some countries are subsidizing the price of oil and insulating their consumers and businesses from the full impact of higher oil prices. It also suggests that those subsidies distort the price of goods produced by various companies. Then they further distort prices on a global scale when they export.
GMJ: Give me an example.
Dr. Jacobe: In theory, if the price of oil goes up, the higher energy price should be reflected in everything that's produced worldwide. So if the cost of oil makes it more expensive to make a T-shirt, that T-shirt should be more expensive everywhere. In reality, if a country subsidizes the energy that supports the creation of those T-shirts and doesn't transmit that price to the consumer, it also creates an artificial imbalance between demand for those products and the demand for oil.
One result of oil subsidies, for instance, is that motorists may be paying higher gasoline prices so other consumers can buy low-cost T-shirts. Those are the artificialities of world pricing. The average driver is inadvertently taxed in the form of high energy prices -- and maybe other commodity prices -- for decisions being made in various individual countries across the globe.
In sum, when one country subsidizes the price of oil, it lowers the relative price of products produced within the country but simultaneously drives up the world price of oil. That's the way the global economy works.
GMJ: So U.S. consumers can buy a cheap T-shirt from a country that subsidizes oil but still end up paying the difference in expensive gas?
Dr. Jacobe: Yes. Distorted prices in one part of the world economy create further distortions around the globe. These price distortions can also create false signals that can be magnified by financial entities like hedge funds to create price bubbles that are really just extraordinarily large price distortions.
In the case of energy, the unintended consequences can become even more bizarre. For example, as a result of distorted global pricing, I think we've transferred the production of some goods from producers who are more efficient energy users to producers who are less efficient energy users because it appears that their production cost is lower.
My argument is that the global price doesn't reflect a truly efficient price in terms of what we might call "free markets." In other words, consumers are paying more than they should in one area because they're paying less than a market price in another area.
GMJ: The U.S. government also does this with farm subsidies.
Dr. Jacobe: Yes, the United States has created significant price distortions. We need look no further for an example than ethanol subsidies and what they have done to food prices. There are many examples from across the globe, and different countries have significantly different perspectives. What one country sees as an "unfair" price distortion might be seen by another country as an essential way to create a safety net for the poor or to provide safe and quality products to their consumers. All of this distorts global pricing.
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GMJ: But this can't be anything new. Haven't the factors that cause these price distortions been around for centuries?
Dr. Jacobe: Yes, but what is new is the magnitude of the effect. The world economy has had different rules for different folks for many hundreds of years. But this is the first time that major countries like China, India, and other emerging countries have seen such enormously rapid economic growth rates, and it's the first time we have seen the true significance of that growth in terms of global supply and demand.
The other thing that's happened is that new technologies and financial innovations have evolved into transmission mechanisms for world trade and globalization. People can invest in various global markets and commodities in a very fluid manner today that they couldn't have years ago. Every speculation that happens on the global markets is transmitted very quickly around the world. As a result, global market fluctuations affect the price of gas at the pump and food in the grocery store almost daily.
GMJ: So why are oil and gas prices declining the way they are?
Dr. Jacobe: In part, I think it has to do with investor perceptions of the global economy. Until recently, many people seemed to believe in something called "decoupling" -- the idea that the U.S. economy could go into recession while the rest of the global economy continued to expand. During this past July, it became increasingly clear that this idea was not going to prove out and that the rest of the world economy was slowing down. As a result, global investor sentiment changed from seeing oil and other commodities as being in a severe shortage worldwide to being more in balance as global demand eased.
Another factor in the pricing equation is the value of the U.S. dollar. Oil is priced in dollars, so as the dollar's value declines, the global purchasing power of the countries selling oil also declines at any given price. To some degree, oil prices increased to offset the U.S. currency devaluation.
Of course, the situation was most likely exacerbated as some hedge funds and other investors began to think of oil and other commodities as a "store of value" that would preserve and possibly enhance their global purchasing power as the value of the U.S. dollar declined. In essence, the demand for oil and other commodity contracts increased because it was seen as serving a dual function -- an important natural resource as well as an important store of value.
Now the dollar is rising in value as investors see that the U.S. economy may be stronger relative to the other developed economies than they once thought. So, as the value of the dollar has increased, oil and gas prices have tended to decline. Still, as the recent volatility in the oil markets illustrates, another bad hurricane or a serious international event that threatens oil production could send oil and gas prices surging again.
GMJ: But is it possible that falling gas prices and the global transmission mechanisms we discussed earlier could hasten the end of the recession?
Dr. Jacobe: It's possible that all of the things that are bad right now -- and that have gotten bad over a long period of time -- could turn around quickly. The real questions are: When will the bottom be reached? When will deleveraging end? And when will real pricing be reestablished?
What's happening right now -- and much of it has to do with globalization, including globalization of the financial markets -- is that many of the things that we used to think were true about the U.S. economy don't necessarily hold true now, at least in the short term. Maybe in the longer term everything will reconcile back to the old ways, but in the short term, a lot of really unusual things are happening -- in fact, it's economically bizarre.
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For example, it's hard for me to believe that the U.S. economy can function very well with oil at $100 a barrel, let alone $140 or more. Today's gas prices are an enormous tax on the U.S. consumer, and government rebate checks simply can't offset that. The government would have to drop money from helicopters continuously to offset the negative effects of today's gas prices -- they are still nearly $1.00 higher per gallon than they were a year ago.
GMJ: You mentioned government. Right now, we're in the middle of the U.S. presidential race. Is there anything the new president or Congress can do to make things better?
Dr. Jacobe: I think Americans and their leaders have to abandon the somewhat romantic notion that "free trade" and "free markets" are the same thing. Economically, "free trade" is absolutely desirable. However, international markets are anything but "free markets." I think political leaders in the United States need to think about how this nation optimizes for both consumers and businesses in the new global economy.
This doesn't mean that we should make other nations, hedge funds, speculators, or even international oil companies out to be villains. These entities are pursuing their own interests in the international economy, and we shouldn't expect them to do otherwise. And if they take advantage of our inability to do the same thing, that is our fault, no one else's.
In this regard, we shouldn't just throw our hands up and assume the "free market" will optimize for the United States in the global economy. Of course, this suggests that U.S. political leaders will have to think and act globally. This will be extremely difficult for groups across the political spectrum. For example, it makes little sense for the United States to limit its energy development options when faced with a global oil and energy oligopoly such as OPEC. Thinking globally suggests that the United States should develop energy every way it can and as cheaply as it can so its businesses can compete most effectively in the world economy.
However, trade arrangements that assume that every foreign product shipped to the United States is safe and meets the standards demanded of our domestic producers also seem pretty silly. Enforcing reasonable product safety standards on all imports is not anti-free trade, it is a recognition that such standards aren't enforced in the global economy unless we do it for ourselves.
And, it makes absolutely no sense for the United States to implicitly guarantee mortgage securities and pass them around the world -- the guarantees should be explicit or nonexistent.
The new U.S. president and Congress will face many challenges early next year. But developing and enunciating a clear strategy for the way the United States will pursue its interests in the new global economy may be the most important challenge -- at least in terms of how it affects the average American. If the next administration optimizes for the United States in the global economy, it will mean good things not just for Americans but also for consumers around the world. I would hope it would also mean fewer price distortions, fewer unintended or unexpected consequences, and a more efficient global economy.
GMJ: I was hoping to end this on a positive note. Is that positive?
Dr. Jacobe: Well, the U.S. economy and political system are marvelous creations. Once we get past the presidential election, our leaders will be able to make a fresh assessment of the U.S. role in the global economy. I'm optimistic that no matter how the election turns out, positive change will result.
-- Interviewed by Jennifer Robison