Friday, February 04, 2005
Invisible Hand you say?
According to Adam Smith, freely set prices are what coordinates the activities of a market economy. Why then are three of the most important prices in the world -- oil prices, interest rates (price of capital) and the price of the dollar -- set by anything but the invisible hand? In this very interesting piece, the Economist Global Agenda investigates the issue.
Thanks to China’s hot economy and America’s cold weather, demand for oil has strengthened over the past month. Thus the rise in the oil price—from $40.25 for a barrel of West Texas Intermediate in early December to over $48 on the eve of OPEC’s meeting—would receive Adam Smith’s blessing: it is the invisible hand at work. But when strong demand drives prices up, high prices are supposed, in turn, to stimulate supply. OPEC, by contrast, is determined to stop oil flowing any faster than it is already. On Sunday, the cartel refused to lift the quota of 27m barrels per day (bpd) that it imposed on its members (with the exception of Iraq) in December. Indeed, it insisted that its members, who are pumping about 500,000 bpd in excess of their quotas, stick to their limits more conscientiously.
OPEC’s complacency depends in part on the Federal Reserve’s credibility. Despite the rise in energy prices, the public is still convinced the Fed has inflation under control. Oil producers can thus enjoy higher prices without fearing the kind of damaging inflationary spiral that afflicted the global economy in the 1970s. Even though energy prices rose by 10.4% at an annualised rate in the last quarter of 2004, core consumer prices, which exclude energy and food, rose by just 2%. The Fed has slowly tightened its grip on the price of money, raising rates by 1.25 percentage points since June. It is expected to raise them another quarter point on Wednesday. But its moves to date have been too light-handed to have much visible impact on the wider cost of borrowing. The yield on American Treasury bonds is a mere 4.1% or thereabouts.
Treasuries are pricey because anyone who wants to buy one must compete with China’s central bank. The People’s Bank of China (PBoC) is, in effect, a “forced buyer” of Treasuries. To keep the yuan pegged at 8.28 to the dollar, it must buy as many dollars as people want to sell at that rate. Despite the controls it maintains on capital inflows, dollars are flooding in. In the last quarter of 2004, the PBoC added another $100 billion to its foreign-exchange reserves. It stores the bulk of these reserves in the official liabilities of America’s government.
According to Brad Setser, a former Treasury official now at the University of Oxford, a dearer yuan would have a more significant effect on capital flows. At the moment, foreign capital is finding its way into China in anticipation of a yuan revaluation. Speculators want to be holding Chinese assets when the currency in which they are denominated jumps in value. The PBoC soaks up this foreign money and recycles large portions of it back into American Treasuries. Once the long-anticipated revaluation actually occurs, the speculation will ebb, and the PBoC will find itself with less money to throw at American assets. As a result, the price of those assets will fall and American interest rates will rise, encouraging Americans to live within their means.
Thanks to China’s hot economy and America’s cold weather, demand for oil has strengthened over the past month. Thus the rise in the oil price—from $40.25 for a barrel of West Texas Intermediate in early December to over $48 on the eve of OPEC’s meeting—would receive Adam Smith’s blessing: it is the invisible hand at work. But when strong demand drives prices up, high prices are supposed, in turn, to stimulate supply. OPEC, by contrast, is determined to stop oil flowing any faster than it is already. On Sunday, the cartel refused to lift the quota of 27m barrels per day (bpd) that it imposed on its members (with the exception of Iraq) in December. Indeed, it insisted that its members, who are pumping about 500,000 bpd in excess of their quotas, stick to their limits more conscientiously.
OPEC’s complacency depends in part on the Federal Reserve’s credibility. Despite the rise in energy prices, the public is still convinced the Fed has inflation under control. Oil producers can thus enjoy higher prices without fearing the kind of damaging inflationary spiral that afflicted the global economy in the 1970s. Even though energy prices rose by 10.4% at an annualised rate in the last quarter of 2004, core consumer prices, which exclude energy and food, rose by just 2%. The Fed has slowly tightened its grip on the price of money, raising rates by 1.25 percentage points since June. It is expected to raise them another quarter point on Wednesday. But its moves to date have been too light-handed to have much visible impact on the wider cost of borrowing. The yield on American Treasury bonds is a mere 4.1% or thereabouts.
Treasuries are pricey because anyone who wants to buy one must compete with China’s central bank. The People’s Bank of China (PBoC) is, in effect, a “forced buyer” of Treasuries. To keep the yuan pegged at 8.28 to the dollar, it must buy as many dollars as people want to sell at that rate. Despite the controls it maintains on capital inflows, dollars are flooding in. In the last quarter of 2004, the PBoC added another $100 billion to its foreign-exchange reserves. It stores the bulk of these reserves in the official liabilities of America’s government.
According to Brad Setser, a former Treasury official now at the University of Oxford, a dearer yuan would have a more significant effect on capital flows. At the moment, foreign capital is finding its way into China in anticipation of a yuan revaluation. Speculators want to be holding Chinese assets when the currency in which they are denominated jumps in value. The PBoC soaks up this foreign money and recycles large portions of it back into American Treasuries. Once the long-anticipated revaluation actually occurs, the speculation will ebb, and the PBoC will find itself with less money to throw at American assets. As a result, the price of those assets will fall and American interest rates will rise, encouraging Americans to live within their means.
