On June 14th, the Financial Times reported that finance ministers from the world’s biggest economies (G8) disagreed with each other on the role of “speculators” in driving politically unacceptable energy prices. Today, the Associated Press adds Saudi Arabia to the list of country’s blaming financial markets for rising prices. The U.S. Energy Secretary declared that insufficient production was to blame for high oil prices, not the popular scapegoat, “speculators.” Perhaps both are right to some extent, but only if you properly define “speculator” to be our very own central bank!

U.S. News & World Report interviewed Kristin Forbes, a professor at MIT’s Sloan School of Management and former member of the White House’s Council of Economic Advisers, to help explain how exchange rates (and therefore, monetary policy) affect gas prices. She highlighted that there are two drivers to oil prices, which are affected by monetary policy: oil is denominated in U.S. dollars on world markets, and fears of inflation drive demand for commodities as a hedge. When the value of the dollar depreciates, oil becomes less expensive for consumers in foreign countries, driving demand in those areas higher.

What makes the value of the dollar fall? In our present scenario, a sustained current account deficit and a Federal Reserve induced decrease in interest rates are the primary culprits. The current account shortfall is driven by a long running trade deficit, meaning the U.S. is consuming a heck of a lot more than it’s producing, with foreigners subsidizing the difference. Our currency is the natural mechanism to adjust for the discrepency, dropping in value so that imports and exports align to correct the imbalance. The second big factor is the inflationary policy of the Federal Reserve, dropping the Fed Funds interest rate, and pumping more dollars into the economy. Steve Forbes writes in Forbes Magazine:

The proof of the Fed’s predominant role in the current disaster: When the credit crisis hit last August, the price of oil was $70 a barrel. Then the Fed began flooding the system with dollars. Today the price of oil is more than $130 a barrel, even though global demand has declined as economic activity has cooled off.

Politicians rarely talk about reality; rather, they choose simplistic explanations that appeal to whatever segment of the voting population to whom they think would be most advantageous to pander. Unconstrained democracy renders politics akin to marketing a commoditized product: splice the population into manageable segments and say whatever you think is necessary to get their votes.

There are a few things that can be done to lower energy prices: increase supply, and/or lower demand. Supply can only be increased by allowing access to currently off-limits territory for drilling. Opponents of this simple solution claim this will adversely harm the environment. Drilling in the U.S. is far cleaner, more efficient, and conducted with stricter environmental standards, than say, drilling off the shore of Nigeria, or Kazakhstan. The other solution is for the Federal Reserve to tighten monetary policy; however, this comes amid concerns of an ailing economy, and would likely make the short term business environment worse. 

This just goes to show that there are no free lunches in economics…tough decisions need to be made, but decisions that are based in reality, not pie-in-the-sky big government schemes. Just this last week, New York Democratic Representative Maurice Hinchey stated that government should take-over oil refineries, a scheme reminiscent of Venezuela’s Hugo Chavez, Bolivia’s Morales, and Stalin’s ingenius (read that sarcastically) economic plans for the ex-Soviet Union. Combined with Congress scapegoating oil executives and “speculators”, and certain Presidential candidates (Democrats) suggesting that punative taxes on oil companies would lower prices, it’s clear our government offers little in the way of a realistic plan.  

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