When should governments act to counter market forces of supply or demand? Liberals would answer: “Whenever a democratic society does not like market outcomes.” Conservatives would say: “Almost never.” Pragmatic economists like me boldly assert: “It depends.”
The perennial question of the effectiveness of government action to change market prices surfaced because of two actions last month. First, the Clinton administration decided to release 30 million barrels of crude oil from the nation’s strategic reserves. On the same day, the Federal Reserve joined the several other central banks—including those of the European Union and Japan—in an effort to drive up the price of the euro.
Elementary microeconomics tells us that a shift in supply or demand will raise or lower the price of any good, whether it is peanut butter or crude oil, cell phones or euros. But the amount of the price change is more complicated.
How big is the shift compared to total supply or demand shifted? How responsive is the price of a particular good to changes in quantity? What happens to expectations about the future? Will last month’s efforts succeed? Regardless of success or failure, will they have unintended negative consequences?
Economic theory and historical experience teach skepticism about such attempts. But a few weeks should give us an answer in any case. Here are some considerations to keep in mind as we watch the situation unfold.
The two efforts were fundamentally alike in that they were both aimed at changing prices. Releasing crude from the petroleum reserve increases short-term supply and puts downward pressure on prices. The Fed and other central banks bought euros in foreign exchange markets, thus increasing demand and putting upward pressure on the price of the euro, which is another way of saying its exchange rate relative to other currencies. In both cases, the quantity is paltry.
The oil release equals about 36 hours of U.S. consumption or less than one half of 1 percent of annual use. It is hard to imagine that will change even medium-term prices very much.
Historically, central banks acting in unison can buy up enough of a weak currency over a few days to temporarily drive up its value. Longer-term successes are scarce because they run out of willingness to throw money into a doubtful cause.
To many observers, these actions were alike in a second way. Both had political objectives. The oil release comes at a crucial time in Al Gore’s campaign and may have some effect in the Northeast, a region both dependent on oil for heating and essential for Gore’s success in six weeks. The euro prop-up comes before a plebiscite in Denmark on whether that nation should also adopt the euro.
Political considerations may explain why orthodox economists such as the Fed’s Alan Greenspan and Treasury Secretary Larry Summers acquiesced in last month’s actions. Ever since Herbert Hoover, policy makers have known that it is better to do something, even if one knows it is only symbolic, rather than risk vilification for not acting at all.
Indeed, many Americans would probably agree that if the petroleum release marginally lowers prices, it is worthwhile and, if it fails, there is no great loss, at least not an immediate or visible one. The weak euro has been hurting U.S. farmers and many businesses. Even symbolic actions will be welcome in these sectors.
Similarly, the Fed would feel bound to respond to a request for cooperation by the Europeans. The United States’ absence from such an effort would be conspicuous, and Fed policymakers know that if they are unwilling to help the Europeans, the Europeans may be grudging in response to any future petitions by the Fed.
Finally, both actions were defended as “sending a message” to markets or “halting speculation.” Markets are not entirely rational, and sometimes a government move may disrupt a price trend based on momentum.
Speculators are a perennial whipping boy. But when intervention is counter to fundamental forces, governments lose credibility. They face the same predicament as the babysitter who faces a defiant child. Threatening more dire consequences than the sitter is willing to actually impose may cow the little hellion into going to bed. But if the child calls the sitter’s bluff, the rest of the evening will be hell.
What is the most likely outcome on these prices? In the days since these actions, we have seen slight drops in oil prices and slight increases in the value of the euro. I would not be surprised to see them drift sideways for a few weeks and then respond to whatever is news then.
What about unintended negative effects? These generally are hard to measure. Theory says that arbitrary government actions to outwit markets induce additional uncertainty that forces producers to factor a risk premium into future investment and pricing decisions.
Opponents of intervention point to Brazil or Mexico as examples of how decades of arbitrary, even whimsical, government attempts to overrule market forces can impoverish societies as a whole.
These two actions, however, were so minor that they are likely to have few significant effects, either positive or negative. The next few months will be fun to watch.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.