To: Sen. Phil Gramm [R-TX], Chairman, Senate Banking
From: Jude Wanniski
Re: Two dollars a gallon
I know you have hooted at the idea that the Federal Reserve caused the worldwide collapse of dollar commodity prices in 1997-98. In light of the current national furor over gasoline prices at $2 a gallon, I think you should reconsider the arguments, which Polyconomics has been making throughout this period. That is, we think the Fed's failure to supply sufficient liquidity to the banking system in the early months of 1997 for the most part caused the price of oil to sink below $10 a barrel, and the damage this did to the world oil industry has caused the current imbalance between the growing demand for oil and the squeeze on fresh supply. If you would contact George Yates, the president of the Independent Petroleum Association of America (IPAA), he will assure you that I made these arguments to him early in 1997, as I watched the price of gold in its decline from the $385 plateau to the $285 plateau -- and predicted the oil price and all other commodity prices would follow. Mr. Yates is a client of Polyconomics and has been for more than 20 years.
Your ridicule of the idea that Fed Chairman Alan Greenspan was somehow responsible for the monetary deflation that afflicted the world economy in this period is understandable. Monetary deflations are extremely rare in the history of the world and we have experienced only a few in the history of the United States. When you got your Ph.D. in economics from the University of Georgia in 1964, I will bet the subject of monetary deflation never arose in any of your classes. The only deflation of note in our history was the experience of 1865-79, when we began the process of leaving the "greenback" financing of the Civil War and returning to the gold standard. The price of gold had floated up to $40 an ounce during the greenback era, dragging commodity prices up with it. When we restored convertibility of paper and gold in the 1870's, doing so at the pre-Civil War price of $20.67 an ounce, commodity prices again fell back with gold. It was with this example in mind that we anticipated the gold price leading the way in 1997 for a sharp decline in oil and other commodities, including the slump in farm prices that has caused so much wreckage in our agricultural sector.
While gold only fell by a third, the price of oil fell by more than 50% in 1997-98, remaining at this incredibly low level into early 1999. Mr. Yates of IPAA helped me understand why the swing was so wide on the downside. He has also helped explain why oil has now swung so high on the upside, forcing the price of gasoline to $2 in many places -- plus wiping out profit margins for independent truckers as diesel fuel also has shot into the stratosphere. On the downside, the low oil price does what low prices always do: It signaled the market not to send capital to develop more supply. Investment in new infrastructure to bring up fresh crude from the vast reserves underground disappeared. For two years the global oil industry sat on its hands, unable to raise capital. Mr. Yates also pointed out that the International Energy Agency in Paris was making a major error in its estimates of productive capacity -- seeing 3 million barrels a day of cushion that Yates said did not exist, but which the markets took seriously. The IEA finally last year quietly acknowledged its blunder by adjusting its numbers, but the damage had been done. Oil would never have dropped below $10 if the IEA numbers had been corrected earlier -- and at the margin there would have been more capital flowing into infrastructure investment. When the Asian economies adjusted to the problems created by the dollar, they joined the buyers of oil and helped produce the current squeeze, which may last through the summer.
Yes, it is hard for you to think of Alan Greenspan being the problem, but it should be much easier for you to see that it is the floating currency itself that is the problem. More than a quarter of a century ago, on June 14, 1974, I wrote an op-ed for the WSJournal called "The Case for Fixed Exchange Rates." It was based on the ideas of Robert Mundell, who last year was given the Nobel Price for economics, and of his protégé, Arthur Laffer. In one relevant paragraph, here is how I put it:
The idea that a fixed system is a market system and a floating system a controlled one is the most difficult Mundell-Laffer concept to see. Its essence is that when rates float, the central bank of each country has a monopoly over its money supply; when rates are fixed, the citizens of the participant countries share in a common money pool with no interference by their respective governments. Under a float, the citizens of the United States, in order to satisfy their money demands, have to rely exclusively on the individuals who run the Federal Reserve to produce the precise money supply to meet demand. Because the individuals at the Fed can never know precisely what the demand is, they can only make rough guesses, and are always wrong in one direction or the other.
If the dollar's rate were fixed to gold, the Fed always would know precisely the demand for dollars and would be able to supply that demand down to the penny. There never would be any mistakes on the upside or the downside. There would be no inflation and no deflation. The world oil industry never would have to guess about the nominal price of oil as it planned for the future. The nominal price and the real price always would be the same. If you think back, Phil, that's where the oil crisis of 1973-74 came from. When President Nixon took us off gold in 1971, the oil industry continued shipping oil to us at $3 a barrel even as the dollars they received bought less and less gold. When gold got to $140, four times its 1971 price, the Middle East oil producers announced they wanted $12 a barrel. Everyone in the world -- except the WSJournal -- blamed the Arab sheiks for jacking up the oil price. Because we knew Professor Mundell's thesis made sense, we knew President Nixon had caused the crisis, having believed in his economic advisors. If you would ask Alan Greenspan, who was around at the time, he will tell you that yes, the WSJournal did make that case, but that nobody paid us any attention. As chairman of the powerful Senate Banking Committee AND as a representative of the oilmen of Texas, you owe it to yourself and the world to take another look.