Visible hands

Feb 1st 2005
From The Economist Global Agenda

Three of the most important prices in the world economy are set by means other than markets. At the weekend, OPEC declared itself happy with the price of oil. On Wednesday, the Federal Reserve will probably raise American interest rates. And on Friday, the G7 will declare itself unhappy with the price of the dollar

PRICES, when freely set, bring order and concord to the unplanned activities of market economies—as if by an invisible hand. But three of the most important prices in the world economy—the price of oil, the price of capital and the price of the dollar—are nudged this way or that by the very visible hands of the Organisation of the Petroleum Exporting Countries (OPEC), the Federal Reserve and the G7. OPEC, the oil producers’ cartel, met at the weekend in Vienna; the Fed, America’s central bank, meets on Wednesday February 2nd; and finance ministers and central bankers from the G7, the group of seven rich nations, congregate towards the end of the week in London, where they will be joined by their counterparts from China and India.

Thanks to China’s hot economy and America’s cold weather, demand for oil has strengthened over the past month. Thus the rise in the oil price—from $40.25 for a barrel of West Texas Intermediate in early December to over $48 on the eve of OPEC’s meeting—would receive Adam Smith’s blessing: it is the invisible hand at work. But when strong demand drives prices up, high prices are supposed, in turn, to stimulate supply. OPEC, by contrast, is determined to stop oil flowing any faster than it is already.

On Sunday, the cartel refused to lift the quota of 27m barrels per day (bpd) that it imposed on its members (with the exception of Iraq) in December. Indeed, it insisted that its members, who are pumping about 500,000 bpd in excess of their quotas, stick to their limits more conscientiously. OPEC also abandoned the target range of prices—$22 to $28 per barrel for a basket of its crudes—that it set for itself in March 2000. The cartel has not hit that target for 14 months.

OPEC maintains that oil prices above $40 or even $50 do not hurt the world economy. As evidence, it points to the fact that last year, oil prices rose by 30% (peaking at over $55 in October) and the world economy grew by about 5%. High oil prices are not inimical to world economic growth, the cartel says; they are a natural consequence of it.

But, of course, the world economy might have grown still faster if oil prices had not risen as sharply. Oxford Economic Forecasting reckons that the price of Brent crude will fall to $41 at the end of the year. But if the price remains instead at $50, it will wipe 0.5 percentage points off GDP growth in America, 0.3 points off that of the euro area, and 0.4 points off growth in Japan, reckons Dresdner Kleinwort Wasserstein.

OPEC’s complacency depends in part on the Federal Reserve’s credibility. Despite the rise in energy prices, the public is still convinced the Fed has inflation under control. Oil producers can thus enjoy higher prices without fearing the kind of damaging inflationary spiral that afflicted the global economy in the 1970s. Even though energy prices rose by 10.4% at an annualised rate in the last quarter of 2004, core consumer prices, which exclude energy and food, rose by just 2%.

According to the Department of Commerce, the American economy slowed in the last quarter, expanding by 3.1% at an annual rate. Surging imports and faltering exports cost it 1.7 percentage points of growth. But the Department now says that exports did not falter quite so badly as it first thought. Canada failed to count about $1 billion-worth of goods and services it bought from its giant neighbour. Thus America's fourth-quarter performance may look somewhat better when revised figures are released on February 25th.

Whatever the doubts about Canada, American demand still looks strong. Consumption rose by 4.6% at an annual pace in the fourth quarter and investment by businesses grew by 10.3%. The Fed has slowly tightened its grip on the price of money, raising rates by 1.25 percentage points since June. It is expected to raise them another quarter point on Wednesday. But its moves to date have been too light-handed to have much visible impact on the wider cost of borrowing. The yield on American Treasury bonds is a mere 4.1% or thereabouts.

Treasuries are pricey because anyone who wants to buy one must compete with China’s central bank. The People’s Bank of China (PBoC) is, in effect, a “forced buyer” of Treasuries. To keep the yuan pegged at 8.28 to the dollar, it must buy as many dollars as people want to sell at that rate. Despite the controls it maintains on capital inflows, dollars are flooding in. In the last quarter of 2004, the PBoC added another $100 billion to its foreign-exchange reserves. It stores the bulk of these reserves in the official liabilities of America’s government.

John Snow, the secretary of America's Treasury, will meet his biggest customer during the G7’s meeting on Friday and Saturday. He and his European colleagues will put pressure on the Chinese to let their currency appreciate. Only if the yuan strengthens, they argue, will America’s record trade deficit begin to narrow.

But a revaluation of the yuan might have little immediate impact on America's trade flows. China accounts for less than a tenth of America’s trade. If the Chinese were to revalue the yuan by 10% it would reduce the dollar’s trade-weighted value by only 1%. Even if China’s Asian rivals and partners followed its lead, revaluing their own currencies by a similar amount, the dollar’s trade-weighted value would fall by only 3.7%.

According to Brad Setser, a former Treasury official now at the University of Oxford, a dearer yuan would have a more significant effect on capital flows. At the moment, foreign capital is finding its way into China in anticipation of a yuan revaluation. Speculators want to be holding Chinese assets when the currency in which they are denominated jumps in value. The PBoC soaks up this foreign money and recycles large portions of it back into American Treasuries. Once the long-anticipated revaluation actually occurs, the speculation will ebb, and the PBoC will find itself with less money to throw at American assets. As a result, the price of those assets will fall and American interest rates will rise, encouraging Americans to live within their means.
Mr Snow, like Adam Smith, may prefer it if prices, including the price of the dollar, are set by the invisible hand of the market. But at the moment, the dollar’s value rests in the hands of the Chinese. And they seem determined to sit on them.

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