November 17, 2000

Oil prices threaten U.S. juggernaut Gridlocked Congress unlikely to bring in needed policies

Marie-Josée Kravis National Post The Florida election recount has overshadowed a very significant vote taken Wednesday by the Federal Open Market Committee. Not only did the U.S. Federal Reserve decide to leave its main policy lever -- the federal funds rate target, used by banks to lend to each other overnight -- at a nine-year high of 6.5%, it also maintained a bias toward further tightening that suggests inflationary pressures continue to cause concern among Fed governors. Many analysts had expected the Fed to shift to a neutral stance, but the central bank argued that despite a recent softening of U.S. economic growth, tight labour markets and rising energy prices threatened price stability.

It seems energy prices in particular have captured the Fed's attention. Despite the repeated pleas of U.S. officials to OPEC and non-OPEC countries, it does not appear that energy prices will weaken substantially in the foreseeable future. Quite the contrary: The world is confronted with a supply squeeze both in production and refining capacity, and there's no prospect of improvements. OPEC cannot make a huge difference at this point because spare capacity is scarce. A weakening of world economic growth would ease demand pressures, but would not eradicate capacity problems.

Large oil companies have simply not been investing in new exploration or production, and have opted instead to buy back their own stocks or to seek merger partners. Unless they are assured a floor price per barrel of US$30 to US$35, they will not risk further investments in deep sea recovery, oil shale, tar sands or major foreign fields such as the Caspian Sea. Likewise, unless environmental legislation is favourable, they will not hazard to increase refining capacity. In other words, a sound energy policy that supports greater capacity and energy independence seems unlikely without a major crisis in the form of much steeper prices or supply cutbacks. The Fed is clearly mindful of the sclerosis that mars U.S. energy policy and the reluctance of big oil companies to be part of the solution.

The current U.S. political ambience is certainly not reassuring. Irrespective of the country's final choice for president, energy policy is likely to be inappropriate. As president, Al Gore would refrain from displeasing environmentalist by allowing more exploration, production and refining capacity and would focus instead on alternative energy sources which, in turn, require the promise of higher energy prices. The longer-term view would overtake concern over the imminent crisis. In any event, an angry Congress would exacerbate an already critical situation.

A Bush administration might be tempted to guarantee a floor price for oil to try to spur investment in new capacity. George W. Bush might also try to keep his promise to allow exploration on government lands in Alaska. But he would soon be accused of being a pawn to big oil, and his shaky support in Congress and in public opinion would in all probablility make him refrain from such boldness.

We are back, then, to the Fed nightmare of continued rises in energy prices and, by extension, a threat of mounting inflation. The Fed would not and could not accommodate these price increases without fuelling more inflation, and herein lies a scenario for a hard rather than a soft landing. Already, the U.S. economy is challenged by tight fiscal and monetary policies. The Fed has succeeded in shrinking money supply and triggering a credit and liquidity squeeze. Scarce liquidity and higher financing costs, combined with softer demand, have already affected corporate profits and will continue to curb earnings growth. Rising energy prices, however, have reduced the Fed's ability to shift monetary policy toward a more stimulative stance.

Similarly, the political bazaar in Washington will prevent any significant easing of fiscal policy at least for the next year or two, even though taxes -- notably payroll taxes -- have risen significantly in the past few years. As Federal Reserve chairman Alan Greenspan stated in a speech in Mexico this week, "good economic performance has made it easier to make good economic policy." He might have added that weakening economic performance requires even more solid policy responses. Unfortunately, the political landscape does not portend such sound decisions.

Gridlock has a certain appeal when it prevents unnecessary government intrusion into market decisions. It is detrimental, however, when it blocks intelligent measures to spur growth, such as tax relief, trade liberalization and incentives to produce more energy and make its use more efficient. The risks are real that the mood in Congress will continue to be excessively partisan. Roughly 40% of current Senators and 60% of the Members of the House have been elected since 1992. During these years of the Clinton administration, Congress has become increasingly partisan, and many members have never experienced the tradition of co-operative legislation and effective trade-offs. The latest election squabbles will merely intensify existing divisions.

It is too early to project a hard rather than a soft landing for the U.S. economy, but it appears that many forces are coinciding to threaten the continued impressive performance of the world's economic leader.

Marie-Josée Kravis is a fellow of the Hudson Institute.

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-- Martin Thompson (mthom1927@aol.com), November 18, 2000