I believe in capitalism. I also believe in the sovereignty of nations. Therefore, I conclude that a global society founded on both capitalism and the sovereignty of nations will inherently have a mixed economy. Some outcomes will be determined strictly by markets, and other outcomes will be determined by sovereign leaders, some elected by democratic processes, and others not.

Most Wall Streeters would agree with what I just wrote. However, most Wall Streeters also petulantly protest whenever sovereign governments intervene in markets, as if such interventions are always an abomination against capitalism. Such was the case on Friday, September 22, when Uncle Sam intervened in both the oil and currency markets. Wall Street bellowed that the Clinton Administration was not only acting foolishly, but in a cravenly immoral political manner.

In contrast, I was not offended either economically or politically (or morally!). To the contrary, I think both interventions were defensible, indeed desirable, on both political and economic fronts. And the reason is simple: The marginal participant in both the oil and currency markets is not a private sector parti-cipant, but a sovereign participant.

History’s Legacy

In the case of oil, the marginal participant is, of course, OPEC and more specifically, Saudi Arabia. In “free” markets, the marginal source of supply is the high cost producer; that’s why the textbook supply curve is upward sloping, to mirror the marginal cost curve. In the case of oil, however, the low cost producer is the marginal source of supply, effectively making the supply curve downward sloping. That, friends, is not a free market! Rather, it is a market that is shaped by (1) where the deity – or nature, if you prefer – decided to distribute the world’s petroleum endowment; and/or (2) where geo political forces – including wars! – drew lines granting sovereignty to nations.

In a free market, private sector participants would seek to buy Saudi Arabia’s petroleum endowment, “arbitraging away” the difference between the global price of oil and the marginal cost of producing it in Saudi Arabia. And then, capitalist instincts would seek to produce it as quickly as possible, since oil, on a levered financial basis, has “negative carry” when in the ground. But as a sovereign nation, Saudi Arabia has the right to use its natural petroleum endowment as it sees fit. The Kingdom can “absorb” putative negative carry on its oil endowment on a levered basis, because it does not own it on a levered basis. Rather, it owns it! Thus, the Kingdom is a natural monopolist. Facts are facts, and political polemical hubris in the developed world, including Texas, can’t change facts.

I have zero, repeat zero, problem with reality. I believe in the sovereignty of nations, just like I believe in capitalism, and simply accept that the petroleum market does not “conform” to textbook models of market-driven capitalism. And since it doesn’t, the price of petroleum is not really market-determined but, rather, politically-determined. The global petroleum market is, to be sure, much closer to being a market-determined market than when the Texas Railroad Commission regulated it, prior to the ascendancy of OPEC. Most important in this regard, petroleum is now freely traded in the futures market, also known as the “paper barrels” market. Thus, sovereign participants in the market now have the “benefit” of market information about demand and supply trends when determining how and when to exercise their sovereign power in the market.

Such market “information” is not, however, an unbiased source of market intelligence, because private sector participants, in placing their bets, start with assumptions about what the sovereign participants will do. Thus, I think it is entirely defensible for sovereign participants to occasionally intervene in the petroleum market, when they conclude that private sector participants have misread their “price-fixing” intentions. Intervention cannot be an abomination to capitalist principles if capitalist principles have already been subsumed by the principal of the sovereignty of nations.

Then & Now: The Committee to Save the World
Requires Fed Participation

Figure 1 is a line graph showing an inversion of euro/U.S. dollar spot rate versus the dollar/yen spot rate, from 120 days before and after a Fed intervention date for each. Spot rates are indexed to 1 at the intervention date. The days are marked on the X-axis, with zero marking the center, the day of intervention. The dollar/yen rate climbed to about 1.06 just before the Fed intervention on 17 June 1998, then sharply fell to 1 around that date. But by 40 days later it reached a new peak of 1.07 before declining below 1. Similarly, the inversion of the euro/dollar rate climbs to about 1.02 just before the Fed intervention date on 20 Sept. 2000, then quickly it falls to 1. It then starts climbing slightly in the 10 days afterwards, embarking on an upward path in the week after the intervention.

Figure 1
Source: Bloomberg

Getting to Know “Backwardation”

In the current state of affairs, the U.S.announ-cement of planned releases from the Strategic Petroleum Reserve, and Saudi Arabia’s concurrent announcement of a unilateral willingness (independent of OPEC) to increase oil supply were “justified” by the perverse private sector incentives associated with pre-vailing market-determined pricing between oil for spot and forward delivery. More specifically, the market was in increasing “backwardation,” in which the spot price was rising ever higher relative to the six month-forward price, as displayed in Figure 2.

Oil Prices and the Term Structure of Oil Prices
Move Inversely...

Figure 2 is a line graph showing the spot price of oil versus the spread of the six-month future to spot, from January 1996 to late 2000. The two metrics moved inversely to one another. In late 2000, the spot price, scaled on the right-hand vertical axis, was around $30, up from a low of about $12 in 1999. Over the same period, the spread, expressed on the left-hand side, trended downward to about negative $1, down from around positive $1.
Figure 2
Source: Bloomberg

As a result of this “backwardation,” the private sector had little incentive to buy physical oil to build inventories for the upcoming winter-driven demand for oil, because oil was priced to fall sharply over the next six months. But the unwillingness to buy physical oil to build inventories was depleting inventories still further, putting even more upward pressure on the spot price of physical oil relative to the forward price, as shown in Figure 3.

...Because Oil Inventories Rise and Fall
with the Term Structure of Prices
Figure 3 is a line graph showing the crude oil stock versus the spread of six-month futures to spot for oil, from January 1996 to late 2000. The two metrics roughly track each other over the period. In late 2000, crude oil stock, scaled on the right-hand vertical axis, was around 280 million barrels, down from a peak on the chart of around 350 million barrels in the first half of 1998. Similarly, the spread, scaled on the left-hand side, wass around negative $1 per barrel in late 2000, down from a peak in the first half of 1998 of about $3.50. But the spread of negative $1 in late 2000 is sharply off a bottom just a few months before of negative $6.
Figure 3
Source: Bloomberg

Thus, there was a clear case, in my view, for the sovereign participants in the market to drive down the spot price relative to the forward price, thereby reducing the disincentive of private sector participants to build spot inven-tories to meet spot winter-driven demand. Re-enforcing that near-term goal was a need to prevent spot prices from going so high as to undermine global aggregate demand, setting the stage for a precipitous fall for oil prices once winter ineluctably turns to spring.

In a nutshell, the U.S. and Saudi Arabia, separately and together, intervened into the oil markets because it was in their own best interests — and the world’s! Were there politics involved? Sure, there were politics involved. But then, politics are by definition involved in markets where sovereign, not private sector players, are the marginal suppliers. In my view, the joint actions taken by the U.S. and Saudi Arabia were the right thing to do. And I would say the same thing if a Republican was sitting in the White House. My only criti-cism of the actions is that they should have happened sooner!

The nature of the oil market is such that (1) wild gyrations in the price of the oil tend to come about when (2) private sector agents expect large changes in the future price of oil, as evidenced by (3) extreme spreads between the spot and forward price, which (4) generate micro-economically rational, but macro -economically irrational changes in desired inventories. Accordingly, it is imminently reasonable for sovereign participants in the market to “take the other side” when private sector participants, for whatever herd-driven reasons, start to expect large swings in oil prices, the very discounting of which become self-reinforcing.

Seeing an Overshoot in the Making

I feel the same way about the coordinated G-3 (and friends) intervention into the currency market, buying Euros for sovereign accounts with both dollars and Yen. Indeed, the case for intervention in currency markets was actually stronger than the case for intervention into the oil market, because money is not a physical commodity like oil, but merely a government promise to create it wisely.

Money is the ultimate fiat commodity – its value in terms of what it will buy in goods and services is always, and everywhere, a political decision. Contrary to the rantings of gold bugs, however, fiat currency regimes are not always destined to end in inflationary ruin. It can, in fact, make sense for the political masters of fiat currency regimes to favor a strong, and stable value for their currency basket relative to goods and services, because monetary stability is associated with maximum possible growth over time. Indeed, I submit that the developed world has been in precisely such an anti-inflation fiat currency regime since 1979, when Fed Chairman Volcker forced not just the United States, but also the world to declare secular war against inflation.

In such fiat currency regimes, sovereigns are the marginal player in the currency market, because only sovereigns can create or extinguish money. This power is not, however, symmetric: It is much easier for a sovereign to protest appreciation than depreciation in its currency, because it is much easier to create than to de-create money. Indeed, this very asymmetry is the dominant restraint on domestic money creation in a fiat currency world: Political leaders know that booms bought with excessive domestic money creation will end in busts and political unemployment. And lest they forget, the famed “capital market vigilantes” stand ready to drill home the message.

At the same time, the capital market vigilantes are not omniscient. Indeed, the history of floating exchange rates in the anti-inflation fiat currency regime in place since 1979 is replete with momentum-driven overshoots of fundamental value. And the reason is simple. The capital market vigilantes rationally exploit the asymmetry inherent in fiat currencies : It is harder to defend a currency than to protest its appreciation.

When a currency pair is moving sharply, the capital market vigilantes inevitably declare that the central bank with the weakening currency is committing inflationary sins, rather than that the central bank with the strengthening currency is committing deflationary sins.

Whether or not this is actually the case doesn’t matter – because ever since 1979, central bankers themselves have preached that inflationary sins are mortal, while deflationary sins are merely venial. Indeed, such is the secular anti-inflation resolve of the developed world central bankers — and also many in the emerging world– that most are now practicing either explicit or implicit domestic inflation targeting . Both academics and the capital market vigilantes applaud this move to inflation targeting.

But they ignore the fact that domestic inflation targeting re-enforces the asymmetry inherent in an anti-inflation fiat currency regime. A weakening currency, by pushing up domestic inflation relative to target, will re-enforce the presumption that the central bank with the weakening currency is committing inflationary sins, even if it is the central bank with the strengthening currency that is committing deflationary sins. To me, this is a prescription for global financial and economic turmoil in the face of an upward shock in global petroleum prices .

This was precisely the backdrop preceding the September 22 G-3 intervention into the currency market, buying Euros for the sovereign accounts with both dollars and Yen. The (1) falling Euro in tandem with (2) rising petroleum prices in the context of (3) an explicit ECB domestic inflation-targeting regime was threatening to “force” the ECB into draconian tightening action. Such a scenario implied (1) increased hard-landing risks in the Euroland economy; (2) a resulting still-weaker Euro, and as its mirror image, a still-stronger U.S. dollar; and (3) battered profits for U.S. companies, and increased hard-landing risk in the United States. Indeed, the capital market vigilantes, acting rationally under the prevailing “rules of the game”, were romancing precisely this scenario and were set to make it happen in a self-fulfilling fashion.

To me, this state of affairs cried out for the G-3 to change the “ rules of the game.” The G-3 needed to refute the presumption that all of the “burden” for dealing with the weak Euro fell upon the ECB, because if that presumption held, there was going to be misery to pay not just for Euroland, but for the world. And the only way for the G-3 to communicate such a change in the “rules of the game” was for the United States to sell the dollar in coordinated buying of the Euro. I applaud the U.S Treasury’s participation in the intervention maneuver. I again hasten to add that I would say the same thing if a Republican was sitting in the White House.

Coordinated currency intervention pacts are by definition political acts. To be effective, they require the commitment of the sovereign leaders of the involved countries. Indeed, coordinated currency pacts are the one “legitimate” avenue for the Treasury to influence Fed policy. The Fed has never liked it that way, but that’s the way it is. Thus, the message of the United States’ involvement in the September 22nd coordinated intervention was both simple and profound : (1) Any further Fed tightening would be a gratuitous act of global deflation; and (2) if the dollar continues to soar against the Euro, despite no further Fed tightening, the Fed will have a responsibility to ease.

The Fed would deny that interpretation, of course, out of fear of accusations that the Fed is becoming “politicized.” In fact, as if to underscore that point, the Fed reiterated its bias to tighten after yesterday’s FOMC meeting. That, friends, was the quintessential political act, masquerading as un-political probity. As long as the dollar is strong against the Euro, the reality of the matter is that the Fed is biased to ease !

So, Will the Interventions Work?

I don’t know. As a portfolio manager, I deeply care, and my hunches are reserved for PIMCO’s Investment Committee. As a citizen and a public commentator, however, I openly applaud the interventions that have unfolded. I believe that the United States did “the right thing” on September 22.

When capitalism threatens to become nothing more than another word for nothing left to lose, something is very wrong with the world. I applaud the sovereign right of nations to exercise their free dumb from Wall Street’s capital market vigilantes.

God bless us all.

Paul McCulley
Executive Vice President
October 4, 2000


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