Market Advisory Features

Crude Arguments
Painful for Some, but Hardly a Crisis

Our Mutual Friend
The Coming Storm
OPEC: Let’s See Them Stick to this One

The G7 and the Duck-billed Platypus

The Next American Empire

Greenspan Sees Red
Heading for a Fall, by Fiat?
A Renewed Force in Asia
The Battle for the Magic Kingdom
Averting A Global Plague





Crude arguments
Mar 23rd 2004
From The Economist Global Agenda

Markets should worry about the surging oil price

NERVES, it is clear, are becoming increasingly frayed in financial markets. In general, the riskier and more generously valued the market, the edgier investors are. They are increasingly fearful about political stability around the world, following the bombings in Madrid, yet more tension in the Middle East and a disputed election in Taiwan. Perhaps even more concerning are worries about the sustainability of global growth. Goldman Sachs now thinks that the world economy will grow by 3.8% this year, not the 4.6% it had originally forecast. The main reason for this sharp reduction is the sustained rise in the price of a commodity long dismissed by most economists as having little impact on mature economies: oil.

That the rise in the oil price might be more than a temporary blip is best illustrated by the price of oil for future delivery. When the spot price of crude (that is, oil for immediate delivery) spiked in the past, notably on the eve of both Gulf wars, the forward price rose only slightly, mainly because the market expected the interruption to be short-lived. This time, not only is the oil price rising, but the forward price is going up sharply, too. On March 18th, the recent high, when West Texas crude rose to $37.93 a barrel, the price for delivery a year hence rose to $32.51, its highest ever.

Last week, the spot price of crude rose to its highest level (in nominal terms) since 1990. The proximate cause was an announcement in February by OPEC, the producers’ cartel, that it would cut production by 1m barrels a day from the beginning of next month. But other factors are at work, too. There have been supply problems both within and without OPEC. Some of these problems are likely to be temporary, but then analysts have been saying this for months.

OPEC’s desire to force the oil price up is almost certainly linked to the falling dollar. All crude is priced in dollars, and exports are thus worth a lot less because the dollar has plunged. Many think that this is one reason why OPEC is happy to see the oil price remain higher than its self-imposed band of $22-28. Possibly, too, Arab-dominated OPEC is rather less enthused by America’s war in the Middle East than George Bush.

If oil supplies have been tight, demand has been expanding briskly, and in China—where else?—it has been growing at a breathtaking pace. China’s rapidly growing economy will account for 40% of the 1.65m-barrels-a-day increase in demand expected this year by the International Energy Agency, according to David Fyfe, one of its analysts. Last year, China overtook Japan as the second-largest consumer of oil after America.

Many argue that the latest jump in oil prices is far more modest than it was in the two oil shocks of the 1970s. In real terms—that is, adjusted for inflation—the price is still a lot lower than it was then. Rich countries are, moreover, far less dependent on oil than they were, because they have become more efficient at making things, and anyway make fewer of them. And the rise in the oil price, as measured in anything other than the beleaguered dollar, has been comparatively trifling. All true, but Buttonwood can’t help feeling nonetheless that many pundits have cried sheep once too often.

In Asia—whose economies are far more dependent on oil for growth than America's—there are, for a start, the risks of higher inflation, or lower growth, or both. Goldman Sachs thinks that Asian growth will bear the brunt of the oil-price rise. Since the region accounted for half of world growth last year (measured on the basis of purchasing-power parity), this is disturbing. To those who have been wondering what ill effects might come from Asian countries’ attempts to hold down their currencies against the dollar, the rise in the dollar price of oil—and, indeed, of just about every other commodity—provides an answer.

China is already on the verge of overheating. But inflationary pressures are mounting elsewhere in the region. If companies do not or cannot pass on the rise in their input costs to consumers, they will either have to cut costs by sacking people (not a policy that finds much favour in China) or accept lower profits.

The effect of the rising oil price on America could be even more disturbing. America may be more efficient than it was, but it is far from immune to higher prices. For consumers, the recent sharp rise in petrol prices—which hit an all-time high this week—is, in effect, an increased tax burden. And it comes just as the effects of Mr Bush’s (official) tax cuts start to wear off.

But there is an indirect effect on consumption, too. Costs are rising for companies as the price of oil and other commodities goes up. In the past, this would have been inflationary: companies simply passed these higher costs on to consumers. But as Stephen King, the chief economist at HSBC, points out, that link seems to have gone, perhaps because of excess capacity at home, or because China’s increasing presence in world trade pushes the prices of manufactured goods and labour down. As a result, wholesale prices have been rising much faster than the price at which companies are able to sell their wares.

To stop profits from falling, American companies must keep a tight lid on labour costs. As Mr King puts it, shareholders have been benefiting at the expense of those who work for them (though not CEOs, of course). A prolonged rise in the price of oil and other commodities would make this problem still more acute: America’s jobless recovery is likely to stay jobless. This would eventually kill the recovery, since consumers in fear of their jobs are unlikely to carry on splurging.

Goldman Sachs now thinks the American economy will grow by only 2.75% (on an annual basis) in the second half of this year and the first half of next—a forecast it has revised down by three-quarters of a percentage point. It might, Buttonwood thinks, even turn out lower than that. Slower economic growth in turn bodes ill for stockmarkets and corporate-bond markets. And if markets tumble, consumer confidence will surely follow. The rise in the oil price, in other words, may leave nerves not so much frayed as in tatters.



Painful for some, but hardly a crisis
Mar 18th 2004
From The Economist Global Agenda

Light crude is hovering around a 13-year high. But are companies protesting too much about high oil prices?

“FOR the last 30 years, the price of oil has been the single most important determinant of the economy and the stockmarket.” So claim the authors of “Oil Factor”, one of a spate of gloomy new books about energy. They claim that the oil price will soar above $100 a barrel “by the end of the decade, and possibly sooner”. Such a spike, they say, would drag the global economy into a severe recession.

You do not need to believe such scenarios (which rest on the dubious assumption of imminent oil scarcity) to be worried about the impact of oil prices today. After all, the OPEC cartel, which controls roughly half the world’s crude exports, has kept prices above $30 a barrel for much of the past three years. In America, petrol prices at the retail pump are approaching all-time highs. Headlines on both sides of the Atlantic have proclaimed an energy crisis.

On the face of it, oil consumers have much to worry about. On Wednesday March 17th, American light crude ended trading in New York at $38.18 a barrel, the highest closing price since October 1990, in the run-up to the first Gulf war. So far this year, consumers have paid an average price of $35 per barrel (based on American light crude), compared with $31 in 2003. Prices have been driven higher in the past week by concerns about terrorism in the wake of the Madrid bombings. Add to that worries about stocks in America: on Wednesday, the government released data showing that gasoline stocks fell last week by 800,000 barrels, to a level 5% below their five-year average, raising fears of a supply crunch (though crude stocks have risen slightly from their near-30-year lows in the winter).

At least for some gas-guzzling industries, the fear of exorbitant prices seems justified. Airlines, for example, have been hit hard by the surge in the price of jet fuel. American, Delta and several others announced a temporary fuel surcharge of $10 per ticket to compensate, only to reverse it when rivals did not follow suit. The chemicals business is also vulnerable, as it uses hydrocarbons both as a feedstock and as a source of energy. Du Pont, the world’s biggest chemicals firm, recently estimated that a $1 rise in the price of both oil and natural gas adds about $135m a year to its pre-tax costs.

But look beyond the most energy-intensive sectors, and the notion that high oil prices are quashing demand and wrecking firms is overdone. One reason is that OECD economies are less energy-intensive than three decades ago when the first oil shocks occurred, thanks to the shift out of manufacturing into services and information technology. And, in real terms, even the current “high” oil price of over $38 a barrel is still below half its historic peak.

The story is further complicated by the recent plunge of the dollar, the only currency in which oil is traded. The relative strength of the euro and sterling has greatly reduced the pain of dollar-price increases for firms in Europe (see chart).

But what of other big oil-guzzling economies? “Americans might whine about it, but they aren’t in pain because the oil price is $35,” argues Roger Diwan of PFC Energy, a consultancy. As evidence, he points to the robust growth in demand for oil in America in recent months—one of the main reasons why prices are now so high.

The same is true of China, which has a currency peg to the dollar and is thus fully exposed to the rising oil price, and has also, like many other developing countries, become much more reliant on oil in recent years as its economy has moved from agriculture to heavy manufacturing. Higher prices have not dented Chinese demand. In fact, China has just passed Japan to become the world’s second-largest oil consumer.

Certainly, some firms in energy-intensive industries are in for a rough ride as OPEC tries to keep prices high through America’s summer “driving season”. Indeed, the cartel shows no sign of reversing its recent decision to cut its official production limit (of 24.5m barrels per day) by 4% from April 1st. But claims that today’s oil prices amount to anything approaching a crisis for business at large are unfounded.



Military strategy

The next American empire
Mar 18th 2004 | WASHINGTON, DC
From The Economist print edition

George Bush and Donald Rumsfeld have pledged to change the way America's armed forces are distributed around the globe. What do they have in mind?


WHEN the second world war and the Korean war had ended, America found itself in possession of what turned out to be some pretty useful territory. The bases used in the Japanese, European and Korean campaigns proved vital in the prosecution of the cold war. During it, the disposition of America's forces petrified, and large concentrations are still in Germany, South Korea and Japan. Now, as George Bush announced at the end of last year, that pattern is being re-thought, in advance of what Donald Rumsfeld, his defence secretary, grandiosely describes as the biggest restructuring of America's global forces since 1945. The outcome will intimate not only America's perception of the threats it faces in the new century, but also its attitude towards friends and alliances.

Three main factors are driving the review. The first is the emergence of new and unpredictable dangers—one of them manifest in Madrid last week. The Pentagon still worries about China and North Korea; about an India-Pakistan conflagration; and about the security of the Gulf. But alongside these concerns are the unknown unknowns of international terrorism, and an arc of post-cold-war instability that stretches from the Balkans to the Caucasus and around the Asian shore.

In the kinds of operations that these new threats may entail, American troops are less likely to have to “fight in place” on the plains of Germany than to get to remote regions quickly. And such wars and skirmishes may turn out to be as controversial as the ousting of Saddam Hussein. This means that America will need to rely on new allies in hitherto neglected regions, and avoid depending on bases in countries that might prove squeamish about pre-emption or prevention. Douglas Feith, a Pentagon official who is helping to conduct the review, says that there is no point having forces in places from which they can't be moved to the fight. The pre-Iraq international rancour is bound to inform such calculations, however much it is now said to be ancient history.

As these new threats have emerged, others have changed or receded—most obviously, Mr Hussein himself. His demise has already led to the withdrawal of most American forces from Saudi Arabia (an “occupation” famously anathema to Osama bin Laden), and the shifting of an air HQ from there to Qatar.

Then there is Kim Jong Il. The hollowing of North Korea's armed forces, and the growing competence and confidence of South Korea's, mean that the South could defend itself much better than in the past against a conventional attack from the north. Plans have already been announced for the South to take over more responsibility from the Americans up near the demilitarised zone. Some in America, who worry that paternalism risks emasculating their country's allies (as well as needlessly consuming American resources), have long advocated such a handover. So some American assets will be moved down the peninsula, where they may be more use for other contingencies, as well as for a counter-attack in the event of an invasion. The main base outside Seoul—a source of friction with the locals, as are the cluster of marine bases on the claustrophobic Japanese island of Okinawa—will move too.

The second important factor is technology. Jobs such as surveillance and reconnaissance can increasingly be done from America itself (and from space). The lighter ground forces that America's army is hoping to field soon should be more easily deployable than today's tanks. The air force can do ever more damage with ever fewer planes. Enemy technology is also a consideration: adversaries may in future be more able and willing to attack American bases in volatile places with missiles and WMD, making those bases more vulnerable and more expensive to maintain.

Given this technological progress, one Pentagon mantra is that its involvement in a region should no longer be measured by the number of boots, tanks and aeroplanes that it has on the ground, but on its “capabilities”—ie, the force that it can bring to bear. That is just as well, since those boots are in short supply and high demand, another of the considerations that will help to shape the global review.

America's active-duty force shrunk by around a third during the 1990s—it now numbers around 1.4m altogether—even as the eruption of small, hot wars made it busier. Now the labour-intensive task of pacifying Iraq is straining America's army almost to breaking point. Before September 11th there was talk of further manpower cuts; many in Congress now want a statutory increase in the army's size. They argue that, as things stand, army recruitment and retention will suffer, especially after units who have already fought in Iraq are sent back.

Mr Rumsfeld is resisting these calls: his budget is coming under pressure; people are expensive and getting more so; and he would prefer to avoid a statutory force increase that would compromise the funds available for the modernisation (or “transformation”) to which he is devoted. (Mr Rumsfeld's unconvincing answer to the Iraq problem is a temporary troop increase, under emergency powers, plus internal army restructuring.) But his global review will need to take account of these strains, as well as those induced by the ongoing deployments in Korea, the Balkans and Afghanistan.

In theory, the first two factors—new threats and technology—suggest a revised global “posture” in which, while retaining some large “hubs”, America also develops smaller, dispersed bases in previously unconsidered regions, as it did in central Asia at the time of the Afghan war. Some of these could be lightly manned or even manless when not in use, and rapidly reinforced by air and sea in times of crisis. Andrew Krepinevich, of the Centre for Strategic and Budgetary Assessments, compares the frontier posts of the Roman empire, which could be (relatively) speedily reinforced by road (see Mr Krepinevich's maps below). Paul Wolfowitz, the deputy defence secretary, also talked recently about the importance, in the disparate “war on terror”, of working with indigenous forces—as America did in Afghanistan, and as Britain regularly did when its own empire sprawled across the globe.

To be specific, Mr Rumsfeld has said there will be changes to the American presence in Japan—home to around 40,000 servicemen—and in South Korea and Germany (though the status of Ramstein air base there seems assured). Although he has also said that he doesn't plan many new bases, there are likely to be new facilities in the countries of his “new Europe”, which are closer to the Balkans and to central Asia than is “old Europe”.

Elsewhere, more Americans may wind up in Africa, and some of the Okinawa marines could conceivably be sent to northern Australia, where they will consolidate one of America's most durable alliances. New naval arrangements in Asia are also being considered. Bosnia will eventually be left to the Europeans. In time, the Pentagon may develop the futuristic concept of offshore bases, loosely based on oil platforms, which might help to circumvent diplomatic and “access” problems, though only up to a point. Meanwhile, more stocks may be pre-positioned in strategic places, and more servicemen—happily for them—will be based back in America.

What might the diplomatic consequences of such a re-jig be? Russia seems prepared to swallow an American presence in Bulgaria and Romania, which are keen on the jobs and extra security that hosting the Americans would bring (though the Russians would like to draw the line at the Baltics). Moving many of the 70,000-odd personnel and around 80,000 dependants based in Germany either east, or west across the Atlantic, will cost Germany jobs and, in the long term, might weaken an old alliance. Military co-operation acts as a ballast when diplomatic relations fray; less of it increases the chances of drift. Yet some newer allies might be less than thrilled with the idea of hosting empty or near-empty bases. As John Hamre, a former deputy secretary of defence, puts it, such countries might ask: “If it isn't a permanent commitment of troops, is it a permanent commitment to our security?”

None of these decisions will be finalised until after an equally sensitive round of base closures in America itself is completed. But if the third important factor—the strain on the force—hasn't receded, the restructuring may turn out to be humbler than Mr Rumsfeld would like. Troops in Germany live in western comfort and with their families. Michael O'Hanlon of the Brookings Institution points out that shifting people to less salubrious bases in eastern Europe or elsewhere would increase the burden on an overstretched force, since those troops would have to be rotated back to America after their tours, with other units taking their place.

Mr Feith says this is a good time to review America's place(s) in the world, because the rationale for doing it is widely understood. But, because of Iraq, this may be the worst, as well as the best of times, to redesign the American empire.



Greenspan sees red
Feb 26th 2004
From The Economist Global Agenda

Deficits do matter, says the Federal Reserve chairman. But not enough to start raising taxes

THE tax cuts George Bush enacted in 2001, 2002 and 2003, though large, were not permanent. Most contain “sunset clauses”, and are scheduled to expire over the next five years. But will the sun ever set on Mr Bush’s tax cuts? Some in Washington think the cuts should be extended because, after all, deficits don’t matter. Alan Greenspan is not one of them. In his testimony to the budget committee of the House of Representatives on Wednesday February 25th, he noted the “growing concern” about the federal budget. Nonetheless, he also voiced his support for making Mr Bush’s tax cuts permanent. The monetary maestro has waded into matters fiscal. And neither side of the House knows whose side he is on.

Owlish in appearance, Mr Greenspan is, by temperament, a deficit hawk. But he is a very long-sighted hawk. Right now, he points out, the budget deficit—$375 billion last fiscal year and expected to grow to more than $500 billion this year—is providing valuable support to the American economy as balance sheets are repaired and excess capacity worked off. Even in the medium term, he said in reply to a congressman’s question, deficits of $400 billion-500 billion would represent a manageable share of a larger national income. He thinks the market has already priced in deficits of this size for the next ten years. Mr Greenspan’s real worries are long-term. He believes the American government has over-committed itself to an ageing population. As the ratio of workers to retirees falls from 3.25 to 1, as it is now, to just 2.25 to 1 by 2025, the burden of pensions will rise remorselessly; the cost of health care incalculably.

To raise taxes sufficiently to meet these commitments would stifle growth and erode the tax base, Mr Greenspan fears. Because raising taxes is dangerous, the Fed chairman believes that Congress should lower them, by extending Mr Bush’s tax cuts into the future. This non sequitur has been gratefully received by the Republican side of the House. But Mr Greenspan combines this recommendation with another: that Congress reinstitute the “pay-go” rules of the 1990s, which require that tax cuts be matched by spending cuts. This recommendation goes down less well with Republicans.

If the budget-setting congressmen who heard Mr Greenspan’s testimony on Wednesday were to take his words to heart, how would they go about their business for the rest of the decade? Extending the tax cuts, as Mr Greenspan recommends, would cost the Treasury $1.7 trillion over the next decade, according to the Brookings Institution. If nothing were done on the other side of the ledger (ie, if real spending per head were held steady) the budget deficit for the year 2014 would stand at $687 billion, the think-tank calculates. But under Mr Greenspan’s pay-go logic, these tax cuts would have to be matched by cuts in spending. Where would the cleaver fall?

The Brookings Institution identifies some choice cuts of corporate pork, politely referred to as commercial subsidies, the removal of which could save the federal government $137.5 billion. For example, air traffic control could be privatised, agricultural prices left unsupported, and fossil-fuel research left to the oil companies. Brookings reckons the federal government could save another $123 billion by leaving education, housing, training, local law enforcement and environmental protection to states and localities. Abolishing manned spaceflight, slowing the growth of the National Institutes of Health and putting the screws on discretionary spending could save a further $56.5 billion. In all, the Brookings budget wonks find $326 billion-worth of savings for the year 2014: no small chunk of change, but not even close to what is needed to balance the budget.

Which is a pity, because the budget outlook only worsens from then on (see chart). As the baby boomers retire, the Office of Management and Budget reckons spending for Social Security will rise from 4.2% of GDP in 2010 to 6.2% by 2040. Spending on Medicare and Medicaid—health-care benefits for the old and poor respectively—is harder to forecast because the costs of new treatments are unpredictable. Nonetheless, on quite conservative assumptions, Medicare and Medicaid expenditures combined will rise from 4.6% of GDP in 2010 to 10.1% in 2040. These projections, said Mr Greenspan, are both vivid and sobering.

Mr Greenspan believes legislators will eventually have no choice but to tamper with health benefits and Social Security. He suggests that retirement benefits might be restrained by stealth, by linking them to a less generous measure of inflation. The “chained” consumer price index he favours adapts to changing patterns of spending. According to this index, the cost of living has risen by just 1.8% in the past three years, rather than the 2.2% rise recorded in the official consumer price index.

Congress may not follow Mr Greenspan’s advice. But perhaps it should heed his example. The best and perhaps the only way to relieve the impending pensions burden is to postpone the retirement age. Mr Greenspan, for one, is 78 next week and still going strong.


Economics focus

Heading for a fall, by fiat?
Feb 26th 2004
From The Economist print edition

The trouble with paper money

IS THE problem with the dollar only that it is falling? It has certainly been doing that. This month, it fell to $1.29 against the euro. This is its lowest-ever rate against the euro, and represents a decline of 19% since the beginning of 2003. In trade-weighted terms, the dollar has fallen less over the same period (15%), but mainly because Asian central banks have been intervening heavily to stem their currencies' rise against it. Of late, it has been wobbling around unconvincingly: America needs a weaker dollar to correct its current-account deficit. But given the dollar's role as a currency of last resort, some wonder if its decline heralds not just an economic adjustment by the United States, but a crisis of sorts in the value of paper money itself.

Money in its present form is a relatively new invention. For most of human history money meant either gold or silver, either directly, or indirectly by means of the “gold standard” which meant, at least in theory, that all paper money was backed by gold. Enthusiasm for the gold standard evaporated in the 1930s, when it made dreadful conditions worse. But it was adopted in a watered-down version after the second world war, when only the dollar was backed by gold. This arrangement made some sense, since America held three-quarters of the world's gold stock. But it came to an end in 1971, when inflationary pressures in America caused the country's manufacturers to become uncompetitive and forced the country off the gold standard. Since then the world has relied on “fiat money”, so-called because it is created by government fiat and is backed only by the promises of central bankers to protect the value of their currencies. It is the value of those promises that some are now questioning.

Certainly, those promises have only been worth much in recent years. In the early years of fiat money, inflation took off, especially in America, in part because of the two oil shocks of the 1970s. This debased the value of the dollar, and the price of gold climbed from $35 an ounce to $850.

It was only in 1979, in his famous “Saturday night special”, that Paul Volcker, then chairman of the Federal Reserve, raised interest rates sharply to clamp down on inflation. The gold price subsequently fell sharply and in its place came a bull market in government bonds that has, with a few sharp interruptions, continued to this day. Although central banks around the world still hold about 30,000 tonnes of gold in their reserves, many have been offloading their stocks over the years. They can earn only a nugatory rate of interest on these stocks (by lending them out) compared with what they can earn on government bonds. For most people, gold has been relegated to the status, in the words of Keynes, of a “barbrous relic”; its price has risen only feebly when investors have fretted about inflation.

Those who doubt the continued worth of paper money as a store of value point to two things. The first is that the price of gold has been rising even though official inflation is low. From $253 an ounce in the late 1990s, gold now fetches just over $400 an ounce, and it rose as high as $430 an ounce earlier this year. It is not just the price of gold that has been rising: so, too, have the prices of precious and base metals. There may, of course, be many other reasons for these rises. China's rapidly expanding economy is gobbling up metals and other commodities for its factories. Moreover, the rise in the price of commodities also reflects the weakness in the dollar: these rises look much less impressive when quoted in euros or yen. But the rise in the price of gold in particular has raised questions.

The biggest of these—and the second main reason for concern—is the amount of debt that rich-country governments have been running up. America's official budget deficit has surged in the three years since George Bush became president, to around $520 billion and climbing. But this is just the shortfall this year. The government's total future liabilities are much larger. In fact, according to a forthcoming book by Laurence Kotlikoff, an economist, the present value of the American government's future obligations, taking into account promised pensions and health-care benefits, is a staggering $45 trillion. European governments are only slightly better at managing their budgets—witness the breaching of the single currency's growth and stability pact. Japan's attempts to coax its economy back to life have left it with a gross national debt of some 160% of GDP, the highest of any big country. No country has tried harder to debase its currency.

In theory, such debts would not be tolerated for long by investors, since the easy way out for central banks is to “monetise” them with inflation. Bond prices would fall (and thus yields rise) as investors worried that they would be paid back in a debased currency. But capital markets currently seem oblivious to spiralling debts. At some 4%, yields on ten-year American Treasury bonds are close to their lowest in two generations, although this is partly explained by huge purchases by Asian central banks. Yields elsewhere are also very low, nowhere more so than in Japan, where ten-year government-bond yields are now 1.3%.

The problem may be that bond investors, far from being far-sighted, are in fact myopic, and are perhaps being fooled by the temporary disinflationary effects of excess capacity and debts built up over the bubble years in both Japan and America. Perhaps, too, investors have been lulled into a false sense of security by the performance of central banks in recent years, and the independence that has been granted to many of them by governments. But this very aura of inviolability may be storing up problems, since it means that governments can borrow still more at cheap rates. And if governments then find themselves crushed by debt, you can rest assured that this independence will be taken away. And then, once again, the paper in your pocket will only be as good as a politician's promise.



Our mutual friend
Feb 24th 2004
From The Economist Global Agenda

Why is so much money pouring into mutual funds?

AN UNUSUAL slip by a great writer, but there is little doubt that the Dickens novel of the title was tautologous: either “a mutual friend” or “our friend” would have been fine. Of course, were Dickens writing now, he might well use the word “mutual” as a sort of shorthand noun. And in that case, the title would be entirely reasonable: for mutual funds—or at least flows into them—have been decidedly friendly to American stockmarkets these past few months. According to Strategic Insight, a research firm, a net $60 billion flowed into equity and hybrid funds in January alone, on top of the $233 billion that investors popped into such funds last year. Strategic Insight estimates that this month the amount of money managed by mutual funds of all descriptions will top $8 trillion. “Without a doubt, mutual funds continue to be the preferred vehicle through which America invests,” says Avi Nachmany in the firm’s press release.

Not Dickens, perhaps, but difficult to deny. Whether investors are sensible to put so much into mutual funds, and equity funds in particular, is, however, a different question. The industry, after all, is not untouched by scandal. Some 20 firms—including ten of the 25 largest—are being investigated by the Securities and Exchange Commission for activities that, in effect, skimmed returns off investors in those funds. Still, a phone call to Mr Nachmany found him in bouyant mood with ready answers to Buttonwood’s queries. The renewed flows, which started to pick up with the stockmarket last April, “reflect tremendous confidence in America’s capital markets”. And the scandals? “Participants in the news are not participating in the upturn,” he says; the money simply “goes from one bucket to another”. Thus have the likes of the Capital Group, Fidelity and Vanguard, which have been untainted by scandal, pulled in billions of dollars of new money. Regulatory scrutiny, says Mr Nachmany, not unreasonably, suggests that whatever is wrong will be fixed. “Faith in the mutual-fund industry remains extraordinary.”

That, at least, is a sentiment with which Buttonwood can concur. The proverbial wall of money, as well as being a sign of confidence in the stockmarket, is used by many as an argument for why it will climb higher. This argument seems flawed. If demand for a product is insanely high, then supply will eventually rise to meet it. Certainly, demand has not slackened in February by all accounts. And, points out Charles Biderman, founder of Trim Tabs, another research firm (which, incidentally, has rather lower, though still very high, estimates for inflows in January), the supply of equity is not so much rising as soaring. Offerings of new shares have recently averaged $1.7 billion a day. In the first six weeks of this year, some $42 billion of new stock was issued—twice the level in the same period last year.

Mr Biderman has a refreshingly harsh view of one reason why this might be so, involving the economics of investment banking: “If you’re paid 4% to 7% to sell new shares and one-tenth of 1% for trading them, what do you think you would want to sell?” The supply of shares from firms’ managers anxious to cash in their chips has also risen, to $600m-800m a day. And stock buy-backs from firms wanting something to do with their spare cash have tailed off sharply. “The new bubble is going to end up like the old bubble,” says Mr Biderman.

Whether the present, apparently insatiable, appetite for equities should be classified as a bubble is a moot point. What is certainly true, as this column has noted before, is that Americans need to invest in apparently turbo-charged assets because they save so little: more than 12% of income in 1981, the personal savings ratio has now fallen to 1.3%. The great American public has instead relied in recent years on heady financial and property markets to save on its behalf. People are now pulling money out of federally insured, low-yielding bank deposits, which had seemed so safe when shares were falling.

In less doubt is that investors’ appetite for risk is very high by historical standards at a time when valuations are already stretched, to put it mildly. Previous columns have touched on corporate debt, both investment grade and junk; on emerging-market bonds; and on the price of shares. None of these markets could be described as cheap. Flows follow returns, and investors generally pull their money out of markets that are and have been falling and put them into those that are going up. This means that they sell assets when they are cheap and buy them when they are more expensive. The huge flow into mutual funds specialising in junk bonds started last year only after that market had enjoyed much of the year’s 28% rise. When the market was at its cheapest, in October 2002, investors were pulling their money out.

The same has been true for equity funds. Shares were at their cheapest that same October, and again in March of last year. In the six months from October 2002, equity funds pulled in a paltry $1.3 billion. By contrast, inflows into equity mutual funds last month were even higher than the previous record of $56 billion, set in February 2000. Those with longer memories than a goldfish might recollect that the stockmarket, or the most exuberantly irrational part of it that hadn’t fallen already, peaked a month after that first record was set, and fell with a series of sickening thuds for another two-and-a-half years. The worst of times, as it were, swiftly followed the best of times.


A renewed force in Asia
Feb 18th 2004
From The Economist Global Agenda

Japan’s economy grew by 7% in the last three months of 2003, its fastest quarterly expansion for more than 13 years. But the Japanese are not celebrating yet

A NEW economic force is rising in Asia. Growing at an annual pace of 7% in the last quarter of 2003, it left both the old guard of Europe and the big shot, America, for dust. With its exports surging by 17.9% (at an annualised rate) in the three months from October to December, its monetary authorities are struggling to keep its currency down. Meanwhile, its firms are scrambling to add capacity to meet the demands of customers at home and abroad: investment in fixed capital grew by 22% in the final quarter of 2003 (again, at an annualised rate).

This new force is not China, the aggressive upstart, but Japan, the forgotten giant of Asia. Its GDP figures for the fourth quarter, released on Wednesday February 18th, were its best for over 13 years. GDP growth of 7% may not be sustainable. The figure may also be flattered by continued deflation: Japan produced 7% more output, but the money value of that output grew by a more modest 2.6%. Still, after a comatose decade or more, Japan’s metabolism may finally be picking up.

The signs have been there for some time. The Bank of Japan has been pumping more money into the country’s anaemic financial system, via more channels than ever before. When the bank’s newish governor, Toshihiko Fukui, says that he will persist until he prevails over deflation, people are starting to think he means it. Corporate profits are improving dramatically; bank lending is still falling, but less rapidly than before. But leaving aside these earlier hints and hopes, the economy’s dramatic performance in the fourth quarter may mark the moment when the rest of the world sits up and takes notice.

Indeed, some of Japan’s economic leaders fear that their counterparts in America and Europe will take too much notice. As the sick man of the Group of Seven (G7) rich nations, Japan could count on the forbearance of other members as it waded into the foreign-exchange markets to manipulate its currency. Last month, Japan spent ¥7 trillion ($67 billion) holding down the yen. Last year, it spent ¥20 trillion. A weak yen is essential to stimulate exports and inflate the economy, argue the Japanese. But that argument is harder to win when your economy is growing so much faster than those of your rivals.

Would a strong yen threaten Japan’s recovery? Certainly, the currency’s 10% gain against the dollar over the course of last year has done little damage as yet to Japan’s trade balance. As long as its main export markets, such as China and the United States, keep growing, its firms should be able to cope with a modest loss of competitiveness in the form of a higher yen.

Besides, one of the more encouraging aspects of Japan’s present recovery is its broad base. Foreign demand contributed about 1.6 percentage points to Japan’s fourth-quarter growth. But domestic consumers chipped in 2 percentage points and firms’ spending on capital added a full 3.2 percentage points.

A stronger yen would make Japan’s exports more expensive. It would also make imports cheaper and monetary conditions tighter. This is perhaps the greater worry for a country still struggling with deflation. According to the GDP deflator, a broad index of prices, deflation tightened its grip on the economy in the fourth quarter, with prices falling at an annual rate of 4.4% (see chart).

But this measure is almost certainly overstated. The GDP deflator reflects the prices of a basket of goods and services, the contents of which change over time to reflect evolving patterns of spending. When the price of a good falls, people buy more of it; hence this good assumes a larger weight in the basket. The GDP deflator thus gives more weight to goods (such as capital goods) whose prices are falling the fastest. Other indicators suggest deflation isn’t getting worse, even if it is slow to get much better. Consumer prices, for example, fell by 0.4% in December, compared with the year before.

So, after so many years of disappointment, are the Japanese finally feeling bullish about themselves? Are they taking a moment to bask in a newly rising sun? Don’t be silly. Sentiment is slower even than the national economy to turn round. By the close of trade on Wednesday, the Nikkei stock index was down by 0.23%.




The coming storm
Feb 17th 2004
From The Economist Global Agenda

Banks are risking ever more of their own money in search of returns. Have they really learned nothing?

IN THE autumn of 1998, Buttonwood was at a conference organised by Credit Suisse First Boston in—appropriately enough—Monte Carlo, when Allen Wheat, the then head of the investment bank, stood up after dinner and delivered a breathtaking mea culpa. Some sort of apology certainly seemed in order given the huge sums the bank had just lost from extravagant punts on Russia in particular and financial markets in general. The bets went spectacularly wrong after Russia defaulted, financial markets went berserk, and Long-Term Capital Management (LTCM), a very large hedge fund, had to be rescued by its bankers at the behest of the Federal Reserve. CSFB eventually admitted to losses of $1.3 billion, though the bank’s official figures and the numbers bandied about by insiders were somewhat at variance. To cut to the chase: had they Mr Wheat’s balls, Buttonwood thinks that the bosses of many a big bank will be making a similar speech before the year is out.

The reason is simple: the size of banks’ bets is rising rapidly the world over. This is because potential returns have fallen as fast as markets have risen, so banks have had to bet more in order to continue generating huge profits. The present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the very risk-management models that banks use. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because—as all past financial crises have shown—the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time.

Even the banks themselves admit that they are taking more risk. Though they do not divulge the size of their positions, or in which markets they are concentrated, the degree by which those positions have grown can be gleaned from the risk-management models that all the big banks use (which are released in their financial statements). So-called value-at-risk (VAR) models determine the amount of capital that banks must set aside against their trading positions, and purport to show how many millions of dollars a bank might lose should markets turn against it. If its VAR is rising, a bank is, in effect, taking more trading risk—and VARs have been climbing for just about all of the banks that dabble seriously in financial markets. The VAR at Goldman Sachs, which is known on Wall Street as a hedge fund with an investment-banking business on the side, has more than doubled. One of the bank’s senior traders was even told recently that he must take still more risk.

Rest assured that he is far from the only one being told this at Goldman Sachs, or anywhere else for that matter, even though it was only a few years ago that many banks specifically eschewed punting as a good way to make money. Earlier this month UBS, a big Swiss bank, said that “with markets and investor sentiment starting to improve” it would gradually increase credit and trading risks. Even the likes of Citigroup, which stopped explicitly trading for its own account a few years back, and HSBC, a bank that used to think of trading as rather common, both announced recently that they too are increasing the amount of trading they do with their own money. Having previously scaled back its own trading, CSFB is also now increasing the amount of money it devotes to trading, though it claims that it will no longer “bet the ranch”. Allied Irish Banks, which you might have thought had had more than its fair share of trading fiascos, having lost nearly $700m thanks to activities of John Rusnak, one of its foreign-exchange traders, is trying to hire another 20 traders in Dublin.

VAR crash

Of itself, VAR is not the best guide to the huge size of banks’ current positions. In simple terms, these models assess the amount of risk that a bank is taking by looking at the volatility of the assets it holds and the correlation between them (the less correlation the better). In that way, banks can see how much they might lose were these bets to sour. A cynic would say that such models thus purport to measure an uncertain relationship between lots of uncertainties.

Crucially, if markets become less volatile, banks can pile on more positions and still have the same VAR. With the exception of Treasuries, markets have indeed become much less volatile—volatility has roughly halved in many financial markets over the past year-and-a-half; equity markets are now less volatile than they have been for a decade. Roughly speaking, if markets are half as volatile, banks’ positions can be twice as large for the same amount of capital. But since VARs have in fact risen, some banks’ positions are probably three times what they were in the autumn of 2002.

Or at least the ones they have on their balance sheets. For banks have been increasing their trading exposures in other ways, too. The most notable is via direct investments in hedge funds, often those set up by traders who used to work for the banks themselves. Chemical Bank, now part of J.P. Morgan Chase, started the trend 15 years ago. Now, almost all big banks invest their own capital in hedge funds. Citigroup may have shut down its “proprietary” trading operations five years ago (temporarily, it now transpires) but it invested a few hundred million dollars of its money in a hedge fund set up by those proprietary traders. Deutsche Bank recently invested $1 billion in a hedge fund run by its erstwhile traders. J.P. Morgan Chase is thought to be the most generous in doling out its cash, but CSFB, Goldman Sachs, Lehman Brothers and BNP Paribas together also invest hundreds of millions of dollars of their shareholders’ money in hedge funds.

In total, banks have invested many billions of dollars in such funds. The reason, apart from an understandable desire to invest money with good traders, is that the money invested in this way is counted as an investment, and not as a trading position, so is not included in the banks’ own trading books. Most of the money that banks invest has gone into hedge funds that specialise in bonds and other sorts of fixed-income instruments. Like the banks, hedge funds have been leveraging up their exposures to markets.

All of which is splendidly profitable, as long as markets behave themselves. But the strategy puts banks and hedge funds alike at huge risk if markets suffer a severe shock—a far more common occurrence than banks allow for. Their models (and, yes, hedge funds use VAR models as well) assume a certain level of losses for moves of a given magnitude. The problem comes for the tiny number of crises when markets move much more and, to add insult to injury, banks’ assumptions about the diversity of their portfolios are shown to be wrong. In other words, the models, says one regulator with a chuckle, are of least use when they are most needed.

By regulatory fiat, when banks’ positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become more than a little crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences.

It could well happen again. There are any number of potential flashpoints: a rout in the dollar, say, or a huge spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to get out of. Think, if you will, of the extraordinary rise in the price of emerging-market debt and junk bonds. “I used to sleep easy at night with my VAR model,” said Mr Wheat in his speech in Monte Carlo. Suffice to say that he suffered a sleepless night or two when that model was found wanting—and that bank bosses could be in for many a sleepless night this year.



The battle for the Magic Kingdom
Feb 13th 2004
From The Economist Global Agenda

Comcast, America’s biggest cable company, has launched an audacious $66 billion bid for Disney. The timing is shrewd, for Michael Eisner, Disney’s boss, is under attack for poor governance and disappointing results

WITH viciously perfect timing, Comcast, a cable-TV company, this week launched a hostile takeover bid for The Walt Disney Company, arguably America's best-known entertainment company. Comcast is taking advantage of a particularly weak point in Disney’s history. Last month Disney’s most important business partner, Pixar, an animation studio, abandoned it. At the end of last year, two board members, Roy Disney and Stanley Gold, resigned and started a campaign to oust Michael Eisner, Disney’s boss. On the day that Comcast announced its bid this week, Disney’s executives started an investor conference in Florida, an occasion they had counted on to boost the company and its share price. The share price did indeed jump, but this was thanks to Comcast's bid, initially worth $66 billion, rather than to any of Disney's business plans.

At its get-together with investors, the Disney high command behaved as if the Comcast bid had never happened. Indeed, the bidder's name was barely mentioned, until Mr Eisner joked that “we're buying Comcast” when asked about possible acquisitions. The Disney boss also argued against the sort of consolidation that media distributors like Comcast have pursued. Perhaps foreshadowing the arguments that Disney's lobbyists will make in Washington, Mr Eisner said: “Concentration of distribution usually hurts the small guy [not] the large player.”

Earlier in the week, Mr Eisner had rejected merger talks, according to Comcast. This was “unfortunate”, the cable giant argued in a letter to him, because strategically the deal makes sense. Putting Comcast, which has 21m cable subscribers, together with Disney, wrote Brian Roberts, president and chief executive of Comcast, would unite its distribution power and technology know-how with Disney’s peerless content businesses. Although the jury remains out on whether vertical integration really delivers value, other firms have already pursued such a strategy. Rupert Murdoch’s News Corp, for instance, has satellite distribution plus its Fox content businesses. Time Warner unites cable with a film studio and television programming—as well as, thanks to its horribly bubbly merger with AOL in January 2000, the internet. But a merger between Comcast and Disney would create by far the biggest vertically-integrated entertainment giant of them all, with a market capitalisation of over $120 billion, says Comcast, compared with Time Warner’s current $78 billion.

Disney’s board of directors said this week that it will carefully evaluate the proposed deal—in the current litigious climate, it would be crazy to do otherwise. Regulators and politicians too will scrutinise it aggressively, even though there are no obvious competition grounds for blocking it, since Comcast and Disney mostly operate in different businesses.

Weapons of mouse destruction

Beyond grand strategic dreams—which some observers reckon that the hard-nosed sorts who run Comcast cannot really take seriously—Disney’s appeal may be that its assets are clearly greatly undervalued, whilst those of Comcast (which so far plans to pay with shares) are, arguably, overvalued. Disney’s crown jewel, for instance, is ESPN, America’s most-watched sports network. Comcast is particularly keen to own ESPN, as it currently has to pay high and rapidly rising fees to carry it on its cable channels.

Under Disney’s current management, the firm’s profits are now a third lower than they were in 1998, and its share price is at the level it was in 1997. Part of the reason for the poor performance is sheer bad luck: Disney’s theme parks, which make up nearly a quarter of its revenue, suffered badly in the wake of the terrorist attacks of September 11th 2001, and because of subsequent economic weakness—they are recovering now, if slowly. A more intractable problem is the broadcast network, ABC, which Disney bought in 1995 and is still losing money. With some exceptions, Disney’s movie-making has struggled for ages. It has had big hits, such as “Finding Nemo” last year, which have propelled a significant improvement in financial performance, but these triumphs have mostly been the work of Pixar, the studio which is now divorcing Disney.

Would Comcast, a family-controlled firm with few creative credentials, be any better at managing Disney’s assets? Possibly. In a sort of government-in-exile conference which ran in tandem with Disney’s own efforts this week to talk to its shareholders, Comcast’s management described its plans to improve profits at its target, with special focus on ABC and on the cable networks. Steve Burke, a former Disney executive who used to run ABC, and who is now Comcast Cable’s president, also stressed the need to revitalise Disney’s animation business, which has languished of late. In addition to improved profitability, Comcast said, cost savings could be $300m-500m a year, bringing a total cash-flow boost from the merger of as much as $1 billion annually. Wall Street, to be sure, loves the deal, with one analyst, Jessica Reif Cohen, hailing it as a “perfect, brilliant combination”.

Comcast, which has a well-deserved reputation as a tough negotiator of deals, also has a fine record in arguably an even harder part of the merger process—execution. It bought AT&T Broadband, a company twice its size, 15 months ago, and so far the acquisition is working well—Comcast has managed to slow dramatically the number of cable subscribers being lost by AT&T Broadband. Indeed, Comcast is considered to be America’s best-run cable operator. It has managed—thanks, again, to those negotiating skills—to get cheap programming without ruining relations with its content providers. In 2000, for instance, a war broke out between Time Warner and Disney over the cost of Disney’s cable channels and ended up with Time Warner blocking ABC from transmission. Comcast, meanwhile, had the same fight with Disney, but carried it out in secret, winning what are believed to have been favourable terms.

Above all, Messrs Roberts and Burke appear to believe that most of Disney’s long-term problems have one (easily removed) root cause: Mr Eisner, chairman and chief executive of Disney since 1984. In his first 13 years in charge he impressively raised revenues from $1.65 billion to $22 billion, and market value from $2 billion to $67 billion. But he lost his way some years ago, and the swelling crowd of influential critics of Mr Eisner has surely emboldened Comcast to make its bid hostile.

Mr Eisner seems to have difficulty getting on with people and thereby retaining senior talent. A long list of executives, such as Paul Pressler and Steven Bornstein, have left Disney. Mr Eisner seems to have made insufficient effort to keep up good relations with Steve Jobs, chief executive of Pixar, which has been responsible for over half of Disney’s studio profits in recent years. That Mr Eisner infuriated Mr Jobs, himself a fiery and short-tempered man, was confirmed recently when Mr Jobs unexpectedly ended talks to re-negotiate Pixar’s co-production deal with Disney.

Mr Jobs noted that Mr Eisner told Disney’s board that, after seeing an early cut of “Finding Nemo”, he didn’t think the film was as good as its others—an embarrassing incident since it went on to become the highest-grossing animated feature film of all time. Mr Eisner told the board that, once the film hit movie-theatres, the Pixar people would get a reality check and become easier to negotiate with. On another occasion, Mr Eisner called Mr Jobs a “Shiite” in a Disney board meeting, according to a board member who participated in it.

Losing Pixar should not immediately hurt Disney’s results because the contract between the two firms obliges Pixar to deliver two more films, in 2004 and 2005. Wall Street analysts have thus been fairly upbeat about Disney’s shares, even before the bid—the success of “Finding Nemo” and a cyclical recovery in advertising and visitors to theme parks should boost profits sharply in 2004. Also, Disney has the rights to make sequels to all the films it co-financed with Pixar, a thought that Mr Jobs said makes his executives “sick” since they will have no control over creative quality.

In the longer term, however, Disney faces a huge problem if it cannot improve the quality of its animated films: characters such as Snow White and Mickey Mouse have historically been the creative heart of the firm. Mr Jobs cruelly pointed out last week that not even Disney’s marketing and brand could turn Disney’s latest two home-grown animated films—“Treasure Planet” and “Brother Bear”—into successes: they both “bombed at the box office”. With Comcast in charge, would Mr Jobs reconsider the divorce?

Unhappy family

The Comcast bid provides both succour and a conundrum for two of Disney’s noisiest critics, who would presumably prefer the firm to stay independent: Roy Disney and Stanley Gold, two former board members who resigned their positions in December in order to mount a public campaign against Mr Eisner. Mr Disney, the nephew of Walt, is derided by some Disney allies as a “nut”. But the support of Mr Gold—a shrewd, tough lawyer who put Mr Eisner in his job in the first place—has been helping to create a following among some institutional investors for his “Save Disney” internet campaign.

Whilst Messrs Disney and Gold clearly regard Comcast’s bid as vindication for their campaign, they are as yet uncertain about whether to support the takeover. Perhaps they would prefer Mr Eisner simply to go, so that the firm can remain independent, or (less attractive) a “white knight” to acquire Disney. Indeed, Comcast’s offer may yet trigger either of those outcomes.

Meantime, Messrs Disney and Gold will try to persuade shareholders to oppose the election of Mr Eisner, and three other Disney directors, at Disney’s annual general meeting in Philadelphia on March 3rd. So far, before Comcast bid, Mr Gold was believed to have mustered as much as 15% of Disney’s shareholder vote. Messrs Disney and Gold have also attacked Disney’s corporate governance and choice of directors. Investors should vote against George Mitchell, a former senator, they say, because he has been a paid consultant to Disney and because his other directorships leave him too little time for Disney. Institutional Shareholder Services, a firm which advises institutions on how to vote, added its support to Messrs Disney and Gold this week by advising investors not to vote for Mr Eisner’s re-election.

Whether any plausible white knight would be a more attractive partner than Comcast is debatable; indeed, it is easy to imagine blacker knights now joining the tournament to win Disney. True, Mr Murdoch has ruled out bidding for Disney. But Viacom, Liberty Media and even Microsoft may fancy the firm. Even likelier bidders are two internet firms, Yahoo and InterActiveCorp, whose respective bosses, Terry Semel and Barry Diller, hail fom the entertainment world.

In theory, regulators might ride to Mr Eisner’s rescue and block a merger of Disney and Comcast, but it seems unlikely. After the bid was announced, Michael Powell, chairman of the Federal Communications Commission, said that it would go through the “finest filter”. Mike DeWine, a Republican from Ohio and the chairman of the Senate Judicary antitrust subcommittee, said that his panel would hold hearings on the transaction. Yet Comcast says that it would make the same undertakings not to discriminate against other content firms and distribution networks that News Corp did last year when it acquired DirecTV. With luck, that should do the trick.

Mr Eisner, one of the entertainment world’s great survivors, will no doubt try to fight to the death. He may offer yet more corporate governance reforms—though the easy ones are mostly done. He will point out that Comcast’s opening offer, originally worth $27 a share and falling, is too low—though Comcast has surely known all along that it will have to raise its offer closer to the $35 that Lawrence Haverty of State Street Research says would tempt institutional investors. The fact is, if Disney’s board really wants to keep one of the world’s iconic companies independent, its best strategy may be to replace Mr Eisner forthwith. Otherwise, Comcast will soon be doing it instead.



Let’s see them stick to this one
Feb 11th 2004
From The Economist Global Agenda

The OPEC oil cartel has made a surprise decision to cut its total output by 2.5m barrels per day, or almost 10%. The cut comes despite complaints from oil consumers about the high oil price

AHEAD of the meeting of the Organisation of Petroleum Exporting Countries (OPEC) in Algiers on Tuesday February 10th, there had been little talk of a cut in the cartel’s production quota. After all, the oil price had climbed steeply—to around $35 a barrel for American crude—between September, when the cartel had last decided to cut output, and January. At these levels, OPEC was well above its target price range of $22-28 per barrel. At most, oil consumers thought OPEC would introduce some relatively tame measures to rein in quota-busting within the cartel, estimated at 1.5m barrels per day (bpd). OPEC did say it would take immediate steps to end such cheating. But more importantly, it surprised observers by unveiling a 1m bpd cut in its members’ combined quota of 24.5m bpd from April. The oil price jumped in response to the news. Whether OPEC can hold to this decision is another matter.

The quota cut is predicated on OPEC’s assumption that world demand for oil will fall off as the weather improves in the northern hemisphere. Ali Naimi, Saudi Arabia's energy minister, said the cartel was acting to avert a crash in the oil price. But the decision has upset America, the world's biggest consumer of oil. John Snow, America's treasury secretary, said a cut in output would be “regrettable” and would act as a tax on American consumers. And it may be that OPEC is wrong in forecasting such a sharp fall-off in demand. Its predictive record is far from flawless: its decision to cut production by 900,000 bpd last September was based on a forecast that stocks would climb over the winter, but this proved unfounded. OPEC’s decisions—and its mistakes—matter hugely, since the cartel accounts for about 40% of world oil production.

OPEC's members have pointed out that a weak dollar means the oil price is not as high as it appears for non-dollar importers and, indeed, for many of the producers. This is certainly true for Europe, where the appreciation of the euro and sterling against the dollar has more than compensated for the rise in the oil price. But this argument cuts little ice in America or China, whose currency is pegged to the dollar. Demand for oil has been robust in both countries: the American economy is recovering strongly, and China is sucking in commodities to fuel—literally, in oil's case—its breakneck expansion.

American and Chinese demand is part of the reason why the oil price has remained so high for so long after the end of the war in Iraq (see chart). Many thought the combination of Iraq’s newly liberated, newly productive oilfields and a ramping-up of production by Russia—the world’s second-biggest oil exporter after Saudi Arabia, though not a member of OPEC—would be enough to bring oil prices down, perhaps to below $20 a barrel. But this was not to be.

Why? Quite simply, the oil supply has not flown as easily as oil-hungry consumers had hoped. After much wrangling, the Russian government agreed with OPEC last September to maintain global market stability (ie, not to export too much)—though some doubt Russian oil companies' commitment to this. And despite avoiding major damage to Iraq’s oilfields during the war, the occupying coalition has not been able to protect fields and pipelines from sabotage in the months since Saddam was toppled. Only now are Iraqi production and exports approaching their post-war target of 2.8m bpd and 2m bpd respectively—and these are well below the country’s potential.

Supply has been disrupted elsewhere, too. Production in Venezuela was crippled last year by a huge general strike aimed at unseating the country’s ruler, Hugo Chávez. Mr Chávez sacked around half the workers at the state-owned oil company, hampering the industry’s ability to restore production to pre-strike levels. Unrest in Nigeria also disrupted supply in west Africa.

There are other factors that have jangled nerves in the oil market, even if they have not had an immediate effect on supply. Last month Shell, an Anglo-Dutch oil giant, shocked investors by admitting that it had overstated its proven reserves by 20%. Though this does not affect current production, it has highlighted a problem that all the big oil companies face: working out how they are going to replace the oil that they lift every year. Oil companies must look increasingly to less and less stable regimes and trickier geology to bolster their reserves.

There are also rumours in the market that the Saudis are finding it more difficult to lift oil out of the ground. The Middle East is home not just to the largest oil reserves, but also those that are cheapest to extract. But recently there has been talk among oil analysts that all is not well in the desert kingdom. There is a lot of secrecy surrounding Saudi Arabia’s production and geological data. Matt Simmons, the energy analyst who spotted America’s falling natural-gas supplies in the late 1990s, told Dow Jones this month that he fears for the Saudis’ ability to act as OPEC’s swing producer indefinitely. However, others argue that the Saudis will be able to fix their supply problems, if they throw enough money at them, with the help of oil-services companies like Schlumberger.

But whatever the medium- to long-term prognosis for Saudi oil, the immediate question for the oil market will be the ability of OPEC members to stick to their new quotas. If the past is any guide, expect more cheating. Bad news for OPEC, but a silver lining for consumers.




The G7 and the duck-billed platypus
Feb 10th 2004
From The Economist Global Agenda

The rich countries’ weekend communiqué on exchange rates was vacuous because they all want different things. So expect more of the same

A CAMEL, goes the old saw, is a horse designed by a committee. What that makes this weekend’s statement by the Group of Seven (G7) finance ministers and central bankers is anyone’s guess, but a duck-billed platypus is Buttonwood’s offering. As any fool knows, the platypus is one of only two mammals that lay eggs (the other being the echidna) and so strange does it look—a sort of cross between a beaver and a duck—that when one was stuffed and first brought back to England from Australia in the early 19th century, scientists thought it a practical joke.

The markets seem to have had a similar reaction to the G7 statement—an attempt to reconcile the irreconcilable—and carried on much as usual, which is to say selling dollars and buying lots of euros, sterling and any currency remotely associated with commodities, and rather fewer yen. For those unlucky enough to have missed the G7’s words, here they are: “We affirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely and co-operate as appropriate. In this context, we emphasise that more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.” Which is just about the same statement as that the G7 made after its Dubai meeting last September, except for the bit about “economic areas that lack such flexibility”. It is hard to conceive of a statement more vacuous.

Not that you would have thought this from the comments made by the participants, all of whom seem to have known exactly what was agreed. There was just one snag: none of them seemed to agree on what was agreed. Exhibit one is the extra phrase about flexibility. “The various currencies that are not flexible will recognise themselves. There is not only one, there are quite a few,” said Jean-Claude Trichet, president of the European Central Bank (ECB), which is spitting blood that Asian countries (China and Japan in particular) are stopping their currencies from taking some of the strain of the dollar’s fall. Since January 2002, the euro has risen by about twice as much against the dollar as the yen has. And the Chinese yuan has not moved at all, since it is pegged firmly to the greenback and the Chinese authorities seem happy that it should remain so.

Funnily enough, Japan doesn’t recognise itself as an offender. “The description of lacking flexibility does not fit Japan,” proffered Japan’s finance minister, Sadakazu Tanigaki, to journalists. “Therefore Japan is not one of the countries that are lacking flexibility, and that was understood at this G7 meeting.” This comment is odd in one sense, true in another. Through the Bank of Japan, the finance ministry spent $68 billion in January alone trying to stop the yen rising against the dollar—the largest amount any central bank has ever spent on exchange-rate intervention in a single month. The Bank of Japan now has some $741 billion of reserves and counting—again, the largest reserves any central bank has ever held. And what is that, Buttonwood wants to know, if not flexible?

The truth, of course, is that the G7 statement is a model of vacuity because no one could agree on anything of substance. Neither Europe nor Japan wants its currency to rise much further, if at all. Japan is still trying to conquer deflation and get its economy on a strong footing. The last thing it wants is for the yen to climb to the stars. Likewise, a rapidly appreciating euro poses a threat to Europe’s fragile economy. Of course, the strength of the euro can be exaggerated—in trade-weighted terms, it is at about the same level as when it was launched. Still, it is a worry, and central bankers (Mr Trichet not least) have started to fret about it. The ECB could always cut interest rates further, of course, or intervene in currency markets, as Japan has done so assiduously. But the ECB is reluctant to cut rates because it still worries excessively about inflation. And without help from the Americans, intervention is unlikely to do more than slow the euro’s rise.

And the Americans will most certainly not intervene unless things get seriously out of hand. The Bush administration could not be happier about what is happening in currency markets now that John Snow, the treasury secretary, has learned to keep his mouth shut. For America it is, says one pundit, “the deal of the century”. The administration is delighted that the dollar has fallen as far as it has; insiders say that it would be more delighted still were the currency to fall another 15% or so. And it doesn’t much care who takes the strain. Europe is not the flavour of the month in Washington, DC, to put it mildly. If the ECB is so vexed about the unequal strain the euro is taking, why doesn’t it cut rates? That Japan’s policy sort of works means that it will carry on intervening. This is wonderful for the American economy. Any other country trying to devalue its currency would see its long-term interest rates rise (and sooner or later its short-term rates, too). But in America’s case, bond yields are actually falling, which helps fuel the recovery. In large part, this is because, as the yen rises, the Bank of Japan buys ever more dollars, and the dollars are usually parked in Treasuries: even in the Treasury market, $68 billion is a tidy sum.

None of the Asian countries wants to stop intervening, otherwise their currencies would shoot up and their economies would (more or less) shoot down as exports slowed. For now, moreover, they seem to be quite content to fund Americans’ profligate ways. Of course, this can’t continue for ever. America’s savings rate is just 1.3%, and even the Bank of Japan can’t carry on buying Treasuries like a Japanese housewife in a Gucci shop. At some point, though perhaps not yet, Americans will stop consuming so much, the Asians will stop buying so many Treasuries and everything will go crunch. As a friend says, “It’s a weirdly unstable equilibrium”. Rather like a duck-billed platypus, in fact, though perhaps not as long lived.