London Times: New cloud hovers over global economic horizon

September 26, 2000

UNTIL three days ago, there were two dark clouds hovering over what earlier this year seemed an almost impeccable world economic outlook. Those blots were the relentless slide of the euro and the risk of another oil shock comparable to 1974, 1979 and 1990-91.

In a matter of a few hours on Friday, both these clouds seemed suddenly to lift. Just before noon the massed ranks of the world's central banks launched the biggest and most effective surprise attack on the foreign exchange markets since 1995. The euro gained 5 per cent in as many minutes.

Then, about ten hours later, Bill Richardson, the US Energy Secretary, announced the release of 30 million barrels of oil from the US Government's strategic petroleum reserve (SPR). As a result, the price of crude in New York is now 17 per cent below the $37 peak it hit early last week.

In the short term, therefore, last Friday's events seemed to represent a ringing success for the new economic interventionism that has steadily become more fashionable since the demise of Thatcherism and Reaganomics.

But how much will these actions achieve in the long run? Will they refute Mrs Thatcher's old doctrine that "you can't buck the markets"? Or will they prove that modern left-of-centre governments really understand how to manage the complexities of a capitalist economy better than the market fundamentalists of old?

There seems to be a strong consensus that intervention to defend the euro was a risky, but necessary, gamble which will eventually pay off in terms of greater economic stability and credibility for the governments and central banks involved. The oil market intervention, by contrast, is regarded as an unwarranted interference with market forces, an act of political opportunism that has more to do with the US Presidential election than the world's economic well-being.

In my view, this analysis is valid, except in one respect: conventional wisdom has got the dichotomy exactly back to front. President Clinton's decision to intervene in the oil market will be proved right. The SPR release will push the oil price well below $30 and keep it there. By contrast, the ECB's intervention in the currency market will fail. The euro will fall back to its recent lows and will suffer at least one further severe crisis.

To see why, consider the two main questions that are always asked when governments intervene in financial markets.

First, is the amount of intervention significant in relation to the size of the market?

The central banks' combined intervention last Friday was estimated at less than $5 billion. This compares with an annual capital outflow from the eurozone last year of about $150 billion, or $3 billion a week, and a current account that is now roughly in balance. The ECB, which controls $290 billion in foreign currency reserves, could in theory match the capital outflows. But would it be prepared to spend $12 billion a month for many months running, and would it be allowed to do so by politicians who might start worrying about the potential foreign exchange losses?

Experience suggests a negative answer.

Turning to the oil market, the SPR release of 30 million barrels over 30 days implies a supply rate of one million barrels a day (1mbd). To compare this with America's total consumption of 30mbd, as many analysts are doing, is as silly as comparing the ECB intervention with the total $1,000 billion daily turnover in global foreign exchange markets. The relevant comparison is with the other sources of oil supply. The release rate of 1mbd is almost equivalent to the total current output from Indonesia or half the current output from Kuwait. That is a very significant volume. Another way of seeing the potential impact of 1mbd is to recall that the March 1999 Opec cutback, which triggered a tripling of oil prices, was 1.7mbd.

The US oil intervention also seems more impressive than the ECB currency intervention in terms of staying power.

Since there are 570 million barrels in the SPR the US could, in principle, maintain the 1mbd release rate for nearly two years - even before we consider the possibility of other G7 countries joining in with their 600 million barrels of strategic reserves.

The second key question about all interventions is whether they are bursting a temporary speculative bubble or fighting against a fundamental imbalance of demand and supply.

In the oil market there is clearly a speculative bubble. This is well illustrated by the top chart, which shows that oil cargoes for immediate delivery were trading last week at an unprecedented premium to oil available a month later. This implied that the shortage of oil in world markets is probably a temporary phenomenon, related to speculative buying in anticipation of still-higher prices, rather than underlying physical demand.

In fact, with American oil refineries operating at full capacity it is not at all clear who would buy the additional oil released from the SPR. But the fact that there are no obvious buyers for physical oil (as opposed to speculative oil futures) does not mean that the SPR release is a mistake. On the contrary, it suggests that it implies that oil prices could fall very steeply once SPR oil actually hits the market.

The oil market, like all commodity markets, has an inbuilt tendency to generate speculative bubbles, which burst suddenly in response to new supply. The second chart illustrates what happened the last time the US Government used its strategic reserves, just before the attack on Iraq in the Gulf War. Although everyone knew that the SPR oil would be released as soon as the fighting started, the market reacted dramatically nevertheless. The oil price fell from over $30 to $20 in less than a week.

The situation faced by the ECB in the currency market is very different. It is implausible to suggest that the euro's weakness is caused by unsustainable speculation. I have argued repeatedly on this page that there has been nothing surprising about the euro's weakness. As long as the eurozone economy is growing slower than the US, is suffering from very high unemployment and is subject to an excessively deflationary monetary policy, there is no mystery about the euro's weakness, nor any reason to believe it is "fundamentally" undervalued.

Moreover, there is little sign of the sort of speculative sellign which intervention can - and should - try to defeat. On the contrary (as shown in the third chart based on a monthly survey by Merrill Lynch of fund managers controlling over $7,000 billion in assets) the great majority of investors have remained defiantly bullish about the euro, even as it has sunk. The result is that vast amounts of euro assets are now held by over-optimistic fund managers who are showing big losses. Every time the euro rises they seize the chance to sell, so as to reduce their embarrassing over-exposure. And even if they remain extremely bullish, as implied by the Merrill Lynch survey, they cannot afford to buy more euros because they are overloaded already.

In other words, there are far more forced sellers of euros than there are buyers. This imbalance will be very hard for the central banks to counteract.

Having said all this, I have to admit that the euro at 87 cents has become fairly cheap in terms of relative costs. And the economic prospects for Europe would be extremely bright provided the ECB would just stop raising interest rates and leave the economies to grow.

In the end, the central banks almost certainly could turn around the euro if they were truly determined. If the ECB spent billions of dollars daily for week after week, the forced sellers would finally be exhausted and the currency would probably start to rise.

But will the ECB show such persistence? And if the ECB were truly determined to make the euro recover, why not try a different approach? Why not simply allow the European economy to grow faster by keeping interest rates lower? This would pull private capital back into Europe and buoy the currency up.

Rapid growth is surely a better, and more plausible, solution to euro weakness than bigger and bigger currency intervention. By choosing the intervention route, the ECB risks failure. And failure could provoke a further loss of confidence, a panic-stricken rise in interest rates and even lower European growth. This is the new cloud on the global economic horizon.

http://www.londontimes.com/news/pages/Times/frontpage.html?999

-- Carl Jenkins (Somewherepress@aol.com), September 26, 2000

Answers

Overlooked is the fact that the shortage is not so much crude oil as it is heating oil, diesel, and other refined products. When this becomes clear, look for oil to rise again.

-- JackW (jpayne@webtv.com), September 26, 2000.