Sunday, June 26, 2005

Charles Stein is right - almost

Charles Stein, a columnist for The Boston Globe, Boston, Mass. USA, wrote an interesting piece today, called: “For oil suppliers, politics often subverts markets.”

In it he says: “In the 18th century, Adam Smith understood that when the price of a commodity rises, people will produce more of it until the price eventually comes down. Smith's observation had held true for oil. When oil prices soared in the early 1980s, countries from Mexico to Norway found and pumped more oil, which contributed to a collapse of prices a few years later.”


Compared to then the situation today seems to be different. “In a long list of countries”, he notes, “politics trumps economics and markets aren't being allowed to work.” And his article details the apparent failure of oil producers, among them Venezuela, Mexico, Russia and Indonesia, to respond to higher oil prices by boosting output, increasing investment and improving efficiency. In place of this expected economic activity Charles Stein sees the mucky hands of politics, graft and inefficiency.

He concludes: “I would be more confident about those new supplies if more countries played by the rules of the market. The energy world needs more investment and that will happen only if people with money believe they will be treated fairly and squarely. That may not be politically correct. But it is true.”

And he ends with a plaintive plea: “Where is Adam Smith when we need him?”

First, let us be clear that Charles Stein correctly states from Adam Smith’s legacy. But in his statement perhaps he has missed the importance of the words: “people will produce more of it until the price eventually comes down”. In short, markets are not given to responses that take effect at infinite velocity. There are lags – they give content to the word “eventually”.

Another, less obvious point, is that markets are composed of people and different people read their situations differently. Adam Smith certainly understood this. He showed no illusions about the complicity of “merchants and manufacturers” in their subversion of the markets they operated within. For remember, markets are the summation of the decisions of disparate people, most of whom act independently of each other. Smith noted how “merchants and manufacturers” were given to act against the competitive tendencies of markets by trying to form monopoly practices, including that of curtailing supply so they could reap higher profits in conditions of rising demand.

In the current oil situation, with rising demand and rising prices it is perfectly consistent with Smith’s “Wealth of Nations” for some major players (Venezuela, Mexico, Russia and Indonesia, for instance) in control of oil production to see an opportunity to reap extra profits by allowing supply not to increase quickly. That way tax income rises too. The fact that for various reasons these countries are run by politicians too, who are not inclined to allow market forces to operate, only adds to the normal proclivity of some entrepreneurs to act as Smith predicted they would: sit on their hands and let demand continue to drive up profits from rising prices.

None of this contradicts Adam Smith’s prediction of the tendency of the market to add to supply when demand exceeds current capacity, eventually. There are other suppliers contemplating the same excess demand situation; there is an inevitable lag in new investment taking effect (after finding a ‘safe’ place to invest it) and new exploration to search for and prove new sources of oil, hitherto beyond past price points.

Users of oil also contribute on the demand side because they have every incentive to economise on its use – we can expect this process to work fairly quickly, or at least quicker than for supply to rise. Also, producers will eventually succumb to the reality that their short term restrictions cost them what they could sell if they had more oil available. If they think they can do this before others react too, they can increase volume profits. Of course, when others see themselves losing out they too will increase supply.

So “where is Adam Smith when we need him”? Right where is has long been – in “Wealth of Nations”, the whole book and not just a few isolated quotations from him.

But, let us thank Charles Stein for correctly applying Smith’s legacy to a modern problem. I hope the above helps clarify some of the issues raised by his article.


(Charles Stein is a Globe columnist. He can be reached at stein@globe.com)




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