After the end of the Cold War, policy makers in the West seemed to relax to catch their wind following a long race. It was generally assumed that without the overriding conflict between the West and the Soviet Union the world would enter a period of economic growth, political stability, and evolution into a tolerant, multi-cultural, diverse society of democratic governments, technological progress, and increasing wealth for everyone. It was also widely presumed that international institutions established after World War II to regulate and administer international trade such as the World Bank, International Monetary Fund, World Trade Organization, GATT, etc, would expand to include emerging economies in an orderly world.
The US, with an overabundance of hubris, referred to itself as the “indispensable nation” and the “sole superpower” but seemed to have no foreign policy. It ignored conflicts in the Middle East, the rise of China, de-stabilizing trends in Latin America, and the trials of Russia and the newly-independent former Soviet republics as they struggled to establish new political and economic systems and relationships. Without much in the way of debate or thoughtful analysis the US defaulted to a program of globalization and free trade with anybody and everybody under the general impression the world’s peoples would all march off into a happy future of equality and multiculturalism.
In many ways that is still the vision of policy makers and academicians but it has not worked out that way. That vision has been undermined by new forces and trends, conflicts, economic crises, separatist movements, and changes of world power relationships as various parties vie for dominance.
The Bush Administration came into office with no strategy and shortly afterward the 9/11 attack dominated all foreign policy thinking. The US embarked on a program of incoherent and uncoordinated actions with no clear purpose or long term strategy except some vague idea of stopping Terror and a fantasy that the US could turn the Middle East into a group of Jeffersonian democracies. Sixteen years later, neither goal has been reached; if anything, things are worse.
Mostly this exposed underlying resentments of various groups within so-called “nations” for which the boundaries had little to do with Westphalian principles of establishing national borders. The next Administration was then characterized by ambivalence, dithering, and withdrawal. These trends culminated in the Arab Spring and its following chaos from which the US is retreating and Russia is moving in. Foreign policy journals are still full of academic recommendations to the new Administration that the US should prop up existing international institutions, alliances, treaties, and the current unreliable and volatile international oil market, supply, and price system.
The two views of forces and trends in the world were on display the past week.
The vision of a benign, globalized, multicultural world was on full display in Saudi Arabia where the Saudi Public Investment Fund (PIF) hosted the Future Investment Initiative (FII) and gathered a wide range of CEOs of prominent investment groups, banks, leaders of all the main international financial institutions and industrial groups, and government ministers in Riyadh; dubbed “Davos in the Desert”. Various distinguished panels discussed the current investment climate and trends for the next several decades. Topics included trends in technological innovation, medical and health care advances, smart infrastructure, big data, virtual reality, robotics, artificial intelligence, media and telecommunications, and retail sales and the opportunities for investment in these areas and in the societal and economic disruptions they cause. Perceived threats to these trends seemed to be limited to inequality and climate change. The Crown Prince announced Saudi Arabia will build an all-new city, NEOM, in the northwest part of the country near Jordan and Egypt on the Red Sea. It will be a high-technology city of technological innovation and a world financial center.
During the same week the world of competition and rivalry was also on display. Russia continued its program of investments in oil supply and transport systems in northern Iraq, Iran, and Nigeria and helped the Venezuelans make their bond payment on Friday. Rosneft proposed exchanging their collateral position in CITGO, the Venezuelan-owned US refining company, for interests in Venezuelan oil fields. The Chinese announced they would begin trading an oil contract on the Shanghai Exchange around the end of the year. That contract will be denominated in yuan backed by gold. These actions reflect strategies of the two governments although they will be implemented by “non-governmental” organizations.
Neither of these developments seems to be receiving any attention by US policy makers. Maria Bartiromo of Fox Business News interviewed Secretary of the Treasury Mnuchin at the FII conference. He discussed the US budget, pending tax bills, and the new international effort to stifle terrorist financing but never mentioned the oil price or the potential effect of the Chinese trading contract.
Russia has been a major supplier of oil and gas to Europe for decades. It has demonstrated it has no reservations about using those supplies as a political and economic weapon and its willingness to curtail them for political concessions, causing significant discomfort and economic impact. Russia is now establishing positions of influence and control over many of the world’s oil supply and transport systems; it can be expected to use these as political and economic weapons.
In the material I have seen China has not announced the exchange rate for the yuan to gold for its new oil contract. Nor is it expected China will back all yuan with gold but then it has had different versions of yuan before. Nevertheless, this in effect puts an oil price in gold into play; this has the potential to affect oil markets and the value of the dollar significantly.
Because of its necessary role in modern economies and the size of its market oil has a unique and critical influence on International trade and finance. Marimon, McGrattan, and Sargent (1) published a study showing that in markets trading in commodities or fiat money, goods with low storage costs become a medium of exchange. For about two and a half millennia, small metal discs were commonly used. To indicate quality and quantity of the metal, pictures of emperors and kings typically were stamped on one side and religious symbols or coats-of-arms on the other. The United States tended toward Miss Liberty on one side and eagles on the other.
A medium of exchange for international trade must have certain characteristics besides a low storage cost:
- Sufficient volume to provide liquidity for the size of the trading market.
- Fungible.
- An open market price on public exchanges.
- Quality and quantity certifiable in a widely recognized and accepted format by independent international agencies.
- Exchangeable or traded directly for a large number of currencies or products.
Oil meets these criteria. It may not be convenient to carry oil around to check out at the local supermarket but for storing large amounts of wealth tankerloads of oil in the outer harbor at Singapore or some out-of-the-way ports have a certain convenience for many people; they are outside banking regulations and have some anonymity with respect to ownership. Convertibility to gold will be an added convenience, increase its use as a medium of exchange, and undermine pricing in dollars. Such convenience is enhanced when price increases in some media exceed storage costs.
Recently I watched congressional testimony by the Chairman of the Federal Reserve. She was asked if they considered oil prices in their policy decisions. She answered that yes, oil prices are watched closely because when oil prices increase they contribute to rising inflation and when they decrease they do not. Also, when oil prices went up it was good for the oil companies but bad for consumers and when they went down it hurt the oil companies but was good for consumers. These profound insights were the extent of her comments regarding the effect of oil prices on the economy. No mention of how the price drop in 2014-15, caused by the end of Quantitative Easing by the Fed, collapsed the economies of Russia, Saudi Arabia, Venezuela, Brazil, Mexico, and other oil suppliers throughout the world or on consumer nations and the effect that has had on international relationships. No mention of the starvation afflicting the people of Venezuela, Putin’s decision to establish a strong presence in the oil business outside Russia, Saudi arms purchases, or over 200 oil-company bankruptcies in the US.
Trading contracts for oil backed by gold will have widespread appeal; China has made it clear they intend to use this market and these contracts to disrupt current markets. Russia already is the largest supplier of oil to China and just announced they intend to increase their sales by 600,000 bopd; and they take yuan for it. The Saudis are also a large supplier to China. Russia, Brazil, and Iran already have announced they would prefer to trade oil in a medium other than US dollars. But the US seems not to be paying attention; not the Fed and not the Treasury and not the State Department.
This reminds me of an announcement at the Oil and Money conference in London in November, 1982. A lady named Rosemary McFadden announced she was going to take control of the oil price; this after a decade of chaos in the markets following the Arab Oil Embargo of 1973-4. She was head of the New York Mercantile Exchange and planned to start trading contracts for 1000 barrels of West Texas Intermediate Oil in tanks in Cushing, Oklahoma. It attracted attention in the conference, and some skepticism, but not as much as many other announcements and no attention from US Government foreign or financial policy makers.
Trading started the following March 30 and the pricing system took a while to get established. A major oil price collapse followed in 1986 and oil traded in a narrow price band for the next 20 years. Initiation of the trading contract on the NYMEX was one of the most profound and long-lasting events in the history of the oil business and international relations and contributed to the eventual fall of the Soviet Union. Other exchanges followed, oil is still traded on open exchanges, and, as noted above, China plans to start trading a contract. But policy makers were oblivious at the time. We seem to be ignoring events of similar potential significance again – at our peril. Many people think oil supply markets have always operated as a worldwide fungible market with marginal prices in US dollars determined by open bid and always will.
Not so; disruptive forces directed by people who do not wish us well are operating in the world. Our policy makers cannot remain oblivious; they must recognize these trends and their effects on oil and financial markets and our economy. Americans have always been masters of change; the US must adapt to these changes and develop strategies and policies which will ensure its security and prosperity in a changed world.
(1) Marimon, Ramon; McGrattan, Ellen; Sargent, Thomas J.: “Money as a Medium of Exchange in an Economy with Artificially Intelligent Agents”: Journal of Economic Dynamics and Control 14 (1990), 329-73.