Line up; pay more. That's the refrain everywhere this summer, whether you're getting a fill-up at the gas station or buying a loaf of bread at the supermarket. Gas has doubled in price in the past year and certain foods--especially fresh produce, meat, milk, and eggs--have doubled in price in just three years.
Are these high prices necessary? Are we now beginning to pay for decades of low prices held in check by the Fed's policy of keeping interest rates low (and therefore keeping inflation in check)? Were we underpaying for food and energy before?
Yes and no. Americans historically have paid lower prices for gasoline than many other countries, European countries in particular. Much of the difference was due to subsidized supply. Our taxpayer dollars paid for tax breaks and subsidies to oil companies--not to mention the hundreds of millions of dollars spent on foreign wars and "police actions" to ensure that US companies had unimpeded access to petroleum sources. But those tax breaks, subsidies, and expensive foreign wars are still in effect today, in spite of Congressional Democrats' recent efforts to eliminate a handful of those tax breaks for oil companies, and the forgotten promises by Democrats to end the war in Iraq.
Economists often cite the increased demand for energy in China, India, and other developing countries as the main cause for high oil prices. They are categorically wrong. Yes, there is an increase in demand for energy in the developing world, but the overall supply of oil has not decreased; in fact, the supply has increased. Because of the increase in price, people in the US and Europe have cut back dramatically on their oil use, thereby causing an oversupply of oil on the global market. Yet oil prices continue to set records. This flies in the face of supply-and-demand economic theory which tells us that, as the supply of oil dwindles, the price should increase, and whenever demand lessens or there's an oversupply of oil, the price should drop.
So what is causing the spike in oil prices? We can find the answer by looking at the commodities markets. Oil futures and oil contracts are routinely traded on the commodities markets: sold by companies that extract and refine oil and purchased by companies that make gasoline, diesel fuel, and heating oil available for purchase on the retail market. Once upon a time the commodities markets were governed by regulations that restricted who could buy and sell futures and contracts. To buy a contract, an investor had to prove that he or she represented a company that could take delivery of the actual oil or petroleum products.
In other words, you or your grandmother couldn't just buy an oil contract for 1,000 barrels of oil, specifying a delivery date thirty days in the future, then turn around and sell that contract a week later for a profit. That kind of trading is referred to as "speculation." An economic rule of thumb is that the more speculation there is in a market, the more prices increase, at least for a while. At least until the bubble bursts.
In the year 2000, energy companies pushed a bill through Congress with provisions that largely deregulated the commodities markets. One provision, which economists called "The Enron Loophole," exempted electronic traders from any requirements to prove that they could or would eventually take possession of the actual oil represented by the contracts and futures they were purchasing. Not only did this benefit Enron, which manipulated the market in order to make hundreds of millions of dollars, it also opened up the market to outside investors with no direct interest in oil extraction, refining, and delivery. In other words, after 2000, you and your grandma could buy all the contracts you wanted.
At first the number of outside investors was small. In the year 2000, outside speculation accounted for about 29 percent of the oil-futures market. But once the credit crisis hit in mid-2007 and the stock market started to tank, the commodities markets saw a massive in flow of cash from investors searching for easy ways to make a quick profit. In poured money from hedge funds and pension plans, from wealthy investors and unrelated corporations--all in search of ways to offset their losses on mortgage backed securities and the stock market. Speculation now accounts for about 71 percent of all trading in oil futures, according to the Commodity Futures Trading Corporation, the government agency that has nominal, but not effective, oversight of commodities markets.
With the increase in speculation has come dramatic price increases that are not tied in any way to supply and demand. Oil prices, which used to be fairly stable, now swing as wildly as the stock market. News of a pipeline attack in Iraq? Oil prices skyrocket within hours, as investors frantically buy up contracts in anticipation of an interruption in supply, however small and transitory it may be.
Once we understand that oil prices are no longer connected to supply and demand, two things become instantly clear. First, the Saudis' reluctance to increase oil production is revealed as a practical response to an already oversupplied market. Cranking out more oil would have no effect on the price of oil, but would put a huge strain the Saudis' overburdened infrastructure.
Secondly, recent reports of only slight increases in overall inflation become much less puzzling. Yes, oil and food prices have skyrocketed, but when these two items are subtracted from the equation, all other goods have increased only a tiny bit, and many have actually decreased in price. The items that have increased are ones influenced by the price of transportation, and only a fraction of the true transportation cost is being passed on to the consumer. Companies are afraid to raise the price of nonessential goods too high, because Americans stressed by high gas and food prices aren't doing much shopping for nonessentials. And because companies can't pass on the full increase in transportation costs, they seek other ways to economize, including laying off employees. While the price of oil may not be tied to supply and demand, the price of everything else still is.
Except, of course, for food. Many variables influence the price of food. Unlike oil, the world is suffering under a real shortage of basic foodstuffs. Only part of this shortage is due to the much-discussed and often-lamented increase in demand from developing nations (as if the poor should be blamed for wanting better quality nutrition for themselves and their children). Pundits often point to two other reasons for food price increases: high oil prices (a lot of energy is required to grow, process, refrigerate, and transport food), and biofuel production.
But higher oil prices should only account for a modest increase in the price of food, and the production of sugarcane and corn for ethanol is a very tiny slice of the agricultural market which should have no impact at all on food prices. Four other factors usually ignored by economists and the press are more important in determining the price of a loaf of bread.
First, fertilizer costs have skyrocketed. Composed mostly of phosphates and nitrogen which exist in abundance, fertilizer should be cheap. But corporations are using an increased demand for fertilizer as an excuse to jack up their prices.
Secondly, policies promoted by the World Bank and the IMF have pushed family farmers off the land and turned millions of acres in developing countries over to plantation farms to grow nonessential commodities for export: tea, coffee, tobacco, rubber, etc. This has contributed to the increased demand for food on the world market, as developing countries have lost the ability to grow enough basic foodstuffs to feed their own populations.
Economists often cite bad weather as a reason for the drop in food supplies, but they seldom mention that drought in Australia, Africa, and Southern Europe and flooding in the US Midwest are the consequences of global climate change caused by greenhouse gas emissions. Global warming is now beginning to interrupt the food chain for humans as well as wildlife.
And, finally, food contracts and futures are bought and sold on deregulated commodities markets the same way oil is. In a better world, investors who have no ability or intention of ever accepting delivery of 1,000 bushels of corn would never be allowed to bid on or buy a corn contract, but they can. Hedge funds, pension plans, and wealthy investors are doing it in record numbers. Speculation in commodities markets, which totaled $13 billion in 2003, has jumped to around $260 billion today.
If the US Congress were to close the Enron loophole and pass comprehensive legislation to re-regulate the commodities markets, analysts at MarketWatch.com have estimated that the price of oil could fall by half, and so would the price of gas. Within 30 days after the legislation passes, Americans could be paying a little over two dollars per gallon at the pump. And there's no telling how food prices would be effected, but they wouldn't continue to climb so dramatically.
Democrats in Congress have discussed commodities market regulation, but have felt no urgency to act on this vital problem. If we all telephone or e-mail our representatives, that might change.