Breaking the Paulson Plan

In today’s Wall Street Journal, Professors Diamond, Kaplan, Rajan, and Thaler published an op-ed piece titled, Fixing the Paulson Plan. Despite my considerable respect for this group (I completed my doctoral studies at Chicago), their recommendations are fundamentally flawed.

In their article, the professors start with some important observations. For example, the authors state, “the real concern about the financial sector is that it is undercapitalized, both because of the losses it has sustained and because of the growing risk aversion of lenders. Undercapitalized financial institutions are forced to try to reduce their assets, and, of course, this means they will make fewer loans, even to the healthy portions of the economy.” In fact, I expressed similar observations in my blog post, Batten Down the Hatches, on Wednesday of this week.

The professors also identify a problem with the Paulson plan that I believe is potentially fatal to its success. In their words, “it is not clear how that hypothetical [held-to-maturity] price will be established through competitive auctions.” This is not a detail to be glossed over now and addressed later. It is key to the entire issue. As I wrote in my earlier piece, a reverse auction, as suggested by the Treasury, has the potential to result in transfer prices that are lower than the values at which many banks currently have these securities marked, precipitating further writedowns and further reductions in bank capital.

Despite correctly diagnosing the problems with the banking sector and with the Paulson plan, the authors offer policy prescriptions that are unlikely to improve matters and may further exacerbate the situation. For example, the authors commend Senator Dodd’s suggestion that taxpayers receive contingent equity from the banks, equal to 125% of any losses the government subsequently realizes on transferred assets. So rather than being long the underlying assets, the banks would be short put options with 25% more downside exposure than they had previously. And of course the banks will have none of the upside.

Supporters of this proposal may argue that this arrangement would be beneficial to the banks as long as the government paid above the current market price for the assets. But presumably the strike prices for these put options would also be set at the above-market transfer price. In that case, the banks would immediately recognize a gain equal to the difference between the market price and the above-market transfer price. But unless this transfer could permanently increase the market price of the assets, the banks would be short put options whose intrinsic value was 125% of the difference between the market price and the above-market transfer price.

Perhaps the supporters of this plan are relying on these asset transfers having a permanent impact on their market prices, in which case there may be some economic benefit to the banks, despite the 125% put options. But if the original assets have proven difficult to value recently, the puts would be a nightmare to value, requiring not only current prices for the underlying assets but also assumptions about the volatility of the asset prices – and even the statistical distributions used to model the future asset prices – going forward. And since these options only increase the downside exposure of the banks, they won’t be able to ignore these accounting issues. Overall, the merit of the Dodd proposal appears doubtful.

But the crux of the Professors’ proposal involves two questionable strategies for achieving two laudable goals. In the words of the professors, the first goal is “to ‘liquefy’ certain moribund markets, thus allowing financial institutions to sell illiquid assets.”The second goal is simply “to raise capital levels in financial institutions.”

In pursuit of the first goal, the Professors suggest implementation of the Paulson proposal, in which “Treasury would buy assets through a reverse Dutch auction or some variant, but without any intent to overpay.” In their words, “the idea would be to jumpstart the market by establishing trading prices.” I’m certain the authors didn’t feel that this WSJ op-ed piece was an appropriate forum for discussing financial theory, but they offer no arguments whatsoever, persuasive or otherwise, for believing that liquidity can be re-established in these markets with a government “jumpstart.”

My own view is that a reverse auction, if successful, would allow the market to see the prices at which some institutions were willing to part with these assets. But it wouldn’t allow the market to see the prices at which other private institutions would be willing to purchase these assets. And if the gap between the willing sale prices and the willing purchase prices remained significant – as it appears currently – then the markets would remain illiquid, and this goal would not be achieved with a reverse auction. But on the other hand, some of these Professors are deservedly renowned as experts in modeling these sorts of issues, so it’s quite possible that they could offer some compelling arguments in support of their view. If that’s the case, they could contribute to the public debate by at least summarizing these arguments.

The most problematic proposal offered by these authors is in pursuit of their goal to raise capital levels in financial institutions. In particular, they suggest that government require all financial institutions, healthy and otherwise, to present plans to raise capital levels by 2% of their assets to preserve the stability of the financial system. They also suggest that the government could contribute up to half this amount in exchange for non-voting preferred equity in the event that an institution was having difficulty raising capital in the private market.

The main problem with this idea is immediately apparent simply by considering the supply and demand curves for bank capital. The demand for capital on the part of banks is an increasing function of their equity prices, whereas the supply curve for capital on the part of investors is a decreasing function of bank equity prices. As seen from numerous deals recently, the market for bank capital is currently very active relative to historical norms, and the market for bank capital appears to be clearing fairly well. The effect of this proposal would be to alter the demand curve for capital to have an inelastic segment at the quantity equal to 2% of assets.

Under this proposal, two scenarios are logically possible. First, the 2% floor could be below the current market-clearing quantity, in which case it would have no effect. Bank deals of the sort we’ve seen recently would continue to be arranged at prices determined by the intersection of these supply and demand curves. This proposal would do no harm, but neither would it accomplish anything positive.

The other scenario is that the 2% floor would be above the current market-clearing quantity. In this case, the inelastic segment of the demand curve would intersect the supply curve at a lower price than the current market price. In this case, a government mandate to raise capital would result in a decline in bank equity prices.

Given that the government has only recently introduced bans on the short sale of many hundreds of financial stocks, it would be highly questionable to impose a mandate on the banking sector that either would have no impact or would drive bank stocks to even lower prices.

Of course, the authors suggest that government could offer support for institutions that had difficulty raising the mandated capital via government purchases of up to half the required increase. But this raises other issues. For example, under what conditions would the government conclude that an institution was having difficulty raising capital? If there is no price at which private investors are willing to supply capital, then a government purchase of preferred shares appears futile. And if there is a price at which private investors are willing to supply capital, the government should allow the market to clear at that price. Government participation can alter the demand curve for capital by lowering the effective floor at which the demand curve must become inelastic, so government participation can increase the equity price. But in this plan government participation is only partial, and it only occurs in the context of a government mandate to raise capital. As a result, the net effect is either to lower the equity price or to have no impact whatsoever on either the price or the quantity of bank capital.

The authors suggest that the real benefit of a mandate is that it would remove the stigma associated with banks needing to raise capital. On this point, the Professors appear to be seriously out of touch with the current dynamics in the market. At the moment, there is no stigma associated with capital raising. Goldman Sachs recently raised considerable capital in a series of transactions for which they’ve been widely praised. Morgan Stanley also raised considerable capital recently. In fact, in the current environment, the ability to raise capital is seen as a sign of strength. There simply is no stigma to be overcome by a government mandate to raise capital.

I do believe the Professors make a useful contribution to the debate with their observations regarding the problems with the Paulson plan. But their proposals for fixing the Paulson plan appear to be poor policy prescriptions. The Dodd plan increases bank risk and decreases bank capital unless the asset transfers somehow permanently raise the market prices of the troubled assets – a proposition for which I see no basis. Their view that a reverse auction would somehow ‘’liquefy” the market isn’t supported by any arguments. And their proposal that government require banks to raise capital appears destined to lower bank stock prices – if it has any impact at all. Rather than fixing the Paulson plan, these proposals would appear merely to break it further.

Batten down the hatches

In addition to dealing with the financial tsunami engulfing the banking system, Paulson now has to contend with a surly, mutinous crew. During yesterday’s hearing, Senators characterized Paulson’s plan for buying distressed assets as “half-baked” and a concept rather than a plan. And for good reason. A plan would contain clearly-articulated goals, strategies, and tactics. Paulson’s proposal contains a broadly-stated goal, but the strategies in pursuit of that goal appear misguided, as Paulson appears to have misdiagnosed the problem. And his proposal is virtually devoid of tactics to support his strategy. Given the reception he received in the Senate, his plan appears unlikely to come to fruition as proposed.

Let’s start with the goals. In his prepared statement yesterday, Paulson expressed his goal “…to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy.” I would argue that there’s little reason for the government to care about financial institution failures except to the extent it cares about job losses, tax receipts, or the financial infrastructure supporting the economy, but the goal of well-functioning credit markets certainly is laudable.

But then Paulson goes awry in his diagnosis of the problem facing the financial sector. As he states in his prepared remarks, the “…root cause is the housing correction which has resulted in illiquid mortgage-related assets that are choking off the flow of credit which is so vitally important to our economy.” The analogy here appears to be one of pipes carrying the flow of credit that have become blocked by illiquid assets. According to Paulson, the decline in house prices has caused these securities to become illiquid, and now they’re clogging the pipes. If we could simply remove the illiquid securities from the pipes, the flow of credit could continue unimpeded.

This is a serious misdiagnosis of the problems facing the financial system. It is not the illiquidity of mortgage assets that is creating the problem. Rather, it’s their price declines.

These mortgage securities are financial assets whose underlying claims to real assets are the claims on houses. As house prices have declined, the values of the mortgage securities have declined. As expectations of further declines spread, owners of these mortgages began selling, often at distressed prices. After a while, the market prices for these securities came to reflect the psychology of market participants more than they reflected the fundamentals of the housing market. And as this psychology deteriorated further and became less predictable, many investors decided there was no price at which they were willing to buy these assets. Meanwhile, many mortgage holders anticipated that the market values of these assets would increase to more closely reflect more realistic expectations regarding default rates and recovery values. With buyers and sellers holding such different views of the market, the market became illiquid.

The commercial and investment banks holding many of these mortgages have been required to mark these securities to their market prices, which are considerably lower than their purchase prices in most cases and which are increasingly difficult to determine given the relative illiquidity of these markets. Of course, this process has caused banks to record large losses. And these losses, even if only on paper, have caused reported bank capital to decline considerably. And here is the problem. Many banks no longer have sufficient capital to support their business. Banks either need to obtain more capital or they need to shrink their business. Banks won’t resume typical lending activities until their risk-to-capital ratios return to more comfortable levels. But their efforts to reduce risk are causing further declines in asset prices, which are causing further declines in bank capital.

Paulson’s diagnosis is that mortgage securities have become illiquid and are now blocking the credit pipes. As a result, his prescription is to remove the illiquid securities from the credit pipes so a reasonable flow of credit will be restored. It’s true that the removal of the mortgage securities from the banking sector can help reduce the risks on bank balance sheets. But it’s also true that this process has the potential to further deplete bank capital. For example, if a reverse auction is used to enact the transfer of the securities from banks to the Treasury, as the Treasury envisions, it’s likely that banks will be forced to record further losses on these securities, resulting in a further erosion of bank capital. In this case, it’s possible that the risk-to-capital ratios would deteriorate even further, simply exacerbating the problem. Even after transferring mortgage assets to Treasury, banks may have to sell even more assets in an attempt to reduce risks to a level commensurate with their lower capital levels.

For this process to improve the situation, the transfer of assets will have to be enacted at prices that are higher than the prices at which they’re currently marked, so the banks can record gains on the sales, resulting in an increase in capital.

In his prepared remarks, Paulson was silent on the mechanism to be used to enact the asset transfers. But in a fact sheet released over the weekend, Treasury stated, “The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions.” Without significant collusion, a reverse auction is likely to lead to lower prices and a further deterioration in bank capital.

On the other hand, Chairman Bernanke yesterday gave the impression that he envisioned that this process would lead at some point to these securities being marked at prices more closely reflecting their ‘hold-to-maturity’ value rather than their fire-sale prices. If this could be accomplished, it has the potential to significantly improve the situation. But given yesterday’s reception in the Senate, it appears unlikely that Paulson will be given license to transfer these assets at these higher hold-to-maturity values, particularly in the middle of election season.

If Congress is unwilling to approve the transfer of assets at hold-to-maturity prices, Paulson’s plan is very unlikely to achieve its goals. Many in Congress and most market participants appear to be aware of this. Perhaps even Paulson is aware of this. Perhaps he believes Congress needs to consider and reject this proposal before they will consider more draconian proposals.

In particular, I can think of two proposals that might help improve the risk-to-capital ratios in the banking sector. The first is a simple capital injection by Treasury, most likely in return for preferred stock. Congress would only approve this if it were done on terms that would severely dilute existing shareholders, but if done in sufficient size it probably would be successful at restoring the flow of credit. Second, Congress could suspend mark-to-market accounting for banks. In this case, banks could report their mortgage holdings at prices that more closely reflect Bernanke’s hold-to-maturity values, resulting in reported profits and capital increases. The stock market would be unlikely to react well to this approach, but the resulting reduction in risk-to-capital ratios very likely would lead to a restoration in a reasonable flow of credit.

I suspect there is a reasonable chance that Congress will allow the Treasury to purchase distressed assets -- though on substantially different terms than those proposed by Paulson. In particular, Congress appears reluctant to approve the entire USD 700 bln requested by Treasury. But there also appears to be a reasonable chance that this plan won’t be approved at all. In particular, I suspect there will be counterproposals suggested involving both direct capital injections and the suspension of mark-to-market accounting.

While the eventual result of this political process in unclear, it is clear that Congress and the Treasury are not going to proceed in a straight line toward a quick implementation of the Paulson proposal. As a result, we’re likely to see some resurgence of the storm that hit the banking sector and the credit markets last week. While it’s unlikely we’ll see conditions on the order of last week’s tsunami, I suspect we’re in for some serious turbulence in the coming weeks. In particular, look for renewed elevation in credit default spreads, lower equity prices, a continued scramble for T-bills, elevated swap spreads, lower oil prices, and continued expectations of near-term rate cuts by the Fed.

Rogoff Misdiagnoses the Problem

In his FT article of July 30, ‘The World Cannot Grow Its Way Out of This Slowdown’, Kenneth Rogoff makes some curious arguments. In particular, he identifies excessive demand for commodities and the excessive supply of financial services as the two main problems facing the global economy. And in response he advocates more restrictive fiscal and monetary policies and a greater willingness to allow financial services firms to fail.

Rogoff cites the large increase in commodity prices as prima facie evidence that the global economy is still growing too quickly and hence that commodity demand is excessive. However, one need only consider the oil price increases from 1974-1980 and the price of gold in 1980 to see that commodity price increases do not constitute prima facie evidence of even trend growth.

Rogoff chides central bankers in dollar bloc countries for having “slavishly mimicked expansionary US monetary policy.” While the Bank of Canada has lowered its lending rate in recent months, the Reserve Bank of Australia and the Reserve Bank of New Zealand have significantly tightened policy over this period. Perhaps Rogoff is also referring to Asian countries with managed currencies, such as China? If so, this characterization still appears misleading, as China has been increasing its rediscount rate and has significantly increased its required reserve ratio in recent years. The overall impression is that policy is relatively stimulative in markets operating below capacity and relatively restrictive in markets that appear to be operating above capacity, just as one would expect in a world still dominated by the Phillips curve paradigm.

Rogoff also chides regulators for preventing the failure of firms in the financial services sector, apparently ignoring the considerable consolidation occurring in the sector. The recent acquisitions of Bear Stearns and Countrywide serve as examples of ongoing consolidation, as does the recent acquisition of ABN AMRO, the largest such transaction to date. Regulators may be subject to criticism for failing to provide adequate regulation in certain instances but not for failing to allow consolidation and removal of capacity in the sector.

In short, I believe Rogoff has misdiagnosed the problem. The demand for commodities and the supply of financial services are the consequences of the profound changes that have taken place across the globe. They are not the causes of the current turmoil, and his prescriptions are unlikely to help ease the turmoil or set the stage for a more supportive environment in the future.

Hans Blix: "Why not in Iran too?

Former UN arms inspector Hans Blix has an op-ed piece in today’s International Herald Tribune, in which he criticizes the US approach toward Iran’s uranium enrichment program. Blix points to the recent six-party talks and recent agreement with North Korea, and asks “Why not in Iran too?”

The answers to this question are many and obvious.

Iran sits atop the world’s second largest proven reserve of oil and the second largest reserve of natural gas. It derives significant revenues from the export of oil (though it needs to import both gasoline and natural gas), and the government derives roughly 85% of its budgeted revenues from the sale of oil. The Iranian people are relatively well off.

On the other hand, North Korea holds off mass starvation only through the good graces of China, which provides North Korea with about 70% of its food imports and more than 70% of its oil imports. As a result, North Korea is affected more by the threat of economic sanctions than is Iran. No country has the sort of leverage with Iran that China has with North Korea.

Iran has strategic influence over much of the oil-rich Middle East, and the US has active military engagements in two countries bordering Iran. The Israelis have just fought a battle in Lebanon with Iran’s proxy, Hezbollah, and Iran actively supports Hamas, which refuses to recognize Israel’s right to exist, and which has been battling the Fatah party for control of the Palestinian administration. Iran has been sending Revolutionary Guards and intelligence officers into Iraq, and it appears as if Iranian weapons have found their way into Iraq and are being used against US troops. Iran clearly has a number of ways in which it can make life difficult to varying degrees for the US.

The primary threat posed by North Korea to American interests is the ability of North Korea to destroy Seoul and to eventually threaten Japanese cities. Of course this capability poses a very significant threat, but it’s difficult to use this threat to gain a tactical advantage in negotiations. If Pyongyang were to move against Seoul, presumably North Korea would come under withering attack that would lead to the removal of Kim Jong Il and lead to a tremendous exodus of refugees. Whereas Iran can ratchet tensions with the West by discrete amounts and gauge Western reaction, the North Koreans have only continued recourse to the threat against Seoul.

Of course there are many more differences between Iran and North Korea, including the religious motivations of leadership, distinct regional ambitions, different political systems, and radically different historical experiences with the US. But in some sense, all these differences are beside the point. The real answer to Blix’s question, “Why not in Iran too?” is that the approach taken with North Korea has been an abject failure.

The Agreed Framework reached with North Korea by the Clinton administration did not stop its plutonium projects, and the North Koreans haven’t even disclosed their uranium projects. And of course the North Koreans tested their first nuclear bombs a few months ago. By any stretch of the word ‘success’ the negotiations with North Korea have not been successful.

In recent years, India, Pakistan, and North Korea have all developed nuclear weapons, and have paid very little price for having done so. I believe Iran has learned from their experience and will continue developing nuclear weapons and will pay a similarly small price in return.

What about a military strike against Iranian nuclear facilities? It’s true that in 1981 Israel bombed and crippled Iraq’s Osiraq reactor, which was later completely destroyed by the Americans in the first Gulf war. (Iran first bombed this facility in 1980 at the outbreak of the Iran-Iraq war.) But analysts believe the major elements of the Iranian program are buried deep underground. My understanding is that conventional weapons are unlikely to cripple these facilities. While there have been some reports that the US or the Israelis are planning to use tactical nuclear weapons against these facilities, I remain highly skeptical.

Were the US to use even limited tactical nuclear weapons, the condemnation throughout the world would be deafening. US interests in most parts of the world would suffer extraordinary setbacks, representing a tremendous cost. I can’t imagine a scenario in which US strategists would consider the cost worth paying in order – at beast – to temporarily postpone Iran’s nuclear weapons program.

What about the Israelis? Might they use tactical nuclear weapons against Iran? I don’t believe Israel wants to be the second nation to use nuclear weapons, but many people in Israel believe the country is facing an existential crisis. Were it to use tactical nuclear weapons against Iran, it could expect missile attacks from Iran, withering rocket fire from the Palestinians, possible military retaliation from Syria, and a resounding denunciation from governments the world over. Further, the move would risk further destabilizing Iraq, possibly destabilize Pakistan (now a nuclear nation), and might prompt the Saudis and Egyptians to pursue nuclear weapons of their own.

None of these scenarios are pleasant. But in the end, I believe that there are really only two scenarios with much likelihood at the moment. Either Israel employs tactical nuclear weapons to cripple Iranian uranium enrichment facilities, or the world needs to reconcile itself with a radical Islamic revolutionary government possessing nuclear weapons.

A Natural Gas Cartel Involving Russia and Iran?

Iran recently renewed a proposal to create an OPEC-style cartel for natural gas, to include Russia and Qatar. Vladimir Putin has expressed interest in this idea in the past and has recently expressed interest in discussing the idea further.

As has been reported in much of the financial press, the creation of a natural gas cartel is problematic for a few reasons.

1. 
   Natural gas is more difficult to transport than oil. Gas is typically transported through fixed pipelines and is typically sold via long-term delivery contracts rather than on a spot market. As such, the manipulation of supply to control price is problematic. Liquefied natural gas facilities are being built to ship gas, but the planned facilities are scarce and are likely to remain scarce for the foreseeable future.
   
2. Despite having vast gas resources, Iran still imports natural gas for its own use, though the Iranians would like to become major exporters in the future.
   
3. Russia has not been interested in joining OPEC, primarily because it wants to follow an independent energy policy. And Putin has said already that Russia would not be willing to adhere to natural gas supply quotas.
   
4. Qatar is a firm ally of the US. It has no interest in antagonizing the US by forming a gas cartel with Russia and Iran. In fact, Qatar has expressed disinterest in forming a gas cartel, preferring instead to focus discussions via the Gas Exporting Country Forum – a toothless group created in 2001.
   

Given that Iran doesn’t presently export natural gas, that Russia refuses to adhere to supply quotas, and that Qatar continually expressed disinterest, why are the Iranians and the Russians expressing interest in this idea again – and why now?

In its drive toward regional hegemony in the Middle East, Iran is embroiled in multiple disputes with the US – particularly the issues of its uranium enrichment program and its sponsorship of Hezbollah in Lebanon and Hamas in Palestine.

Given its imbroglios in Iraq and Afghanistan, the US is confined largely to diplomatic efforts to constrain Iran. And given that the EU trio of Britain, France, and Germany have failed in their diplomatic efforts to constrain Iranian nuclear ambitions, the US is increasingly looking toward the UN. By discussing the creation of a natural gas cartel, Iran and Russia are reminding the US that Iran has an ally on the Security Council – a friend anxious to use its veto to thwart US ambitions, particularly in light of Putin’s hostile speech given February 10th at the Munich Conference on Security Policy.

Russia is unwilling to support a program of economic and political sanctions with potential to motivate Tehran to abandon its nuclear weapons goals. For that matter, neither is France – as seen by Chirac’s unguarded and widely-reported remarks to the International Herald Tribune during an interview on January 29th.

Might China play a constructive role in deterring the Iranian nuclear program, similar to the role it played in securing the recent agreement with North Korea? Not likely. China’s own drive toward hegemony in Asia requires China to demonstrate that it can exert control in the region, and North Korea’s testing of a nuclear device last October was an embarrassment for China. As a result, China felt compelled to act to secure North Korea’s agreement. No such motivations exist for China in relation to Iran, and Washington can expect no help from Beijing in securing a similar agreement from Tehran.

As a result, I believe there is no diplomatic route to thwarting Iran’s nuclear ambitions. In this case, either a limited military strike is used in an attempt to stop Iran’s nuclear program, or Iran will acquire nuclear weapons. Either way, the Middle East is likely to become less stable, with consequences for the price of oil, inflation, corporate profits, equity markets, and bond markets. But at least we won’t also be worrying about a natural gas cartel.

Oil, the Fed, and the ECB

The International Herald Tribune today published an article discussing the fact that oil prices decreases are putting pressure on both the Federal Reserve and the ECB to hike rates still further – an interesting argument given the different perspectives of these central banks.

While oil prices were reaching highs of around USD 77 per barrel in 2006, the Fed was downplaying the increase in the headline inflation indices and focusing on the fact that higher oil prices acted as a tax on consumers, which would slow the economy and relieve pressure in measures of core inflation. On the other hand, the ECB was highlighting the risks posed by increases in headline inflation – particularly the risk that the higher headline numbers might result in an increase in the inflation expectations held by labor unions and business leaders during wage bargaining rounds.

Now that oil prices are decreasing, the Fed is expressing concern about the oil’s impact on the economy and the risk that core inflation readings will move higher – consistent with their model of the economy and their general focus on core rather than headline inflation measures.

The ECB appears to be less consistent in its treatment of oil price moves these days. ECB members are highlighting upside risks to core readings for a change – ignoring the downward pressure on headlines measures – and also pointing to possible second-round effects of past oil prices rises.

Is the ECB being intellectually inconsistent – perhaps because of its desire to move rates higher regardless of the economic environment?

In my view, the key driver for the ECB for some time now has been their concern over M3 growth within the eurozone. M3 was growing too quickly for the ECB as oil prices were increasing – and recent data show it growing even more rapidly now. The ECB is one of the most monetarist of central banks, and the market has repeatedly underestimated the concern that ECB members have with rapid money and credit growth.

I attended a dinner with Trichet in New York a few months ago, and I was impressed by his focus on money and credit growth – particularly private credit. More important, he noted that he was surprised that the market hadn’t really appreciated the ECB’s focus on this issue.

A decrease in the price of oil should help to further stimulate the growth in credit components within the eurozone – adding to the ECB’s concerns about inflation over the medium-term. For this reason – more than concerns they have about GDP growth per se or second round effects of previous oil price increases – the ECB is expressing concerns about recent oil price declines.

The transmission mechanism by which the ECB sees oil prices as having an impact on medium-term inflation is money and credit growth, and I continue to believe that the key to forecasting ECB policy this year is forecasting the growth of money and credit balances within the euro area – and anticipating the ECB responses to those increases.

Saudis using oil to constrain Tehran?

The front page of today’s WSJ Europe had an interesting article entitled, “Can Russia, Iran endure oil pinch” highlighting the difficulties that the governments in Russia, Iran, and Venezuala are facing with oil down from a high of around USD 77 in August. More interesting, today’s International Herald Tribune contains an article entitled, “Saudi Arabia’s cryptic signals,” (from yesterday's NY Times) with a key passage:

Oil traders have been buzzing in recent weeks about whether Saudi Arabia was actively seeking to depress oil markets in the hope of crippling the Iranian economy, as a Saudi analyst — albeit not one from the government — suggested in an opinion article in The Washington Post last year. The Saudis quickly dismissed the suggestion, but given the tensions in the Middle East, oil and politics remain closely linked.

Though not reported in the NY Times article, the analyst in question, Nawaf Obaid, was the director of the Saudi National Security Assessment Project in Riyadh, an adjunct fellow at the Center for Strategic and International Studies in Washington, and a consultant to the Saudi Embassy in Washington. After publishing the article in question, Prince Turki, the Saudi ambassador, terminated the embassy contract with Obaid, ostensibly to distance himself from the policy outlined in the article.

The buzz is that the former Saudi Ambassador and long-time friend of the Bush family, Prince Bandar, is advocating the policy outlined by Obaid in the Washington Post article: namely that the Saudis will fund the Iraqi sunnis in the event of a premature US withdrawal from Iraq -- and also that the Saudis will increase the supply of oil on the market in order to push the price low enough to hurt the Iranians and to limit their ability to fund the Shiite insurgency in Iraq and Hezbollah in Lebanon. It's understood that Prince Turki advocates another policy – one involving a regional dialogue to include the Iranians -- and that his resignation was in protest to Bandar’s continuing contacts with the US Administration. (Bandar and Turki are both said to be maneuvering to replace Turki’s ailing brother, Prince Saud al-Faisal, as Saudi Foreign Minister.)

Besides Saudi efforts to pressure Iran, there are of course numerous other reasons offered for the decrease in the oil price since August of last year, including:

• A milder-than-expected hurricane season in the Atlantic;
• Milder-than-expected December temperatures in the northeastern US and in Europe; and
• Oil exporter concerns over the investment in alternative energy.

Also mentioned have been global slowdowns in the US and in China, but recent data suggest growth has actually been more robust than had been expected in both economies.

My longer-term expectation had been that oil prices would decline from their highs, as oil producing nations try to head off the large investment that could help develop alternative energy sectors. My understanding was that this hadn’t taken place yet because years of underinvestment had left the Saudis and others with little ability to dramatically increase production. In that light, my near-term expectation was that oil prices would increase as global growth continues apace.

But recent articles about the Saudis moving to increase production so as to lower the oil price and cripple Iran have given me cause to reconsider. If the Saudis have been able to increase production – and have an ability to increase production still further – their interest in restraining Tehran and in slowing the growth of alternative energy sources are two good reasons for them to attempt to engineer still further price declines.

So – a few key questions to research:

• Have the Saudis increased production by a meaningful amount in recent months?
• Do they have the ability to increase production significantly going forward?
• Which Saudi faction will win the debate about Middle East policy, particularly as it pertains to the use of oil prices as a lever vis-à-vis Iran?
  

The answers to these questions may be as important to discerning trends in oil prices these days as any analysis of the demand side.