Economics / History / Warfare

Aggregate Demand Dominance: Price Controls’ Nemesis—Oil Embargoes and the Onset of Stagflation

The Utter Failure and Stupidity of the Gold and Silver Standards: Part 6

Stagflation’s onset became apparent after the Arab Oil Embargo. Imposed by OAPEC states that were allied with or were belligerents in a war with Israel, oil prices and inflation soared:

The dominant view of scholars and professionals is to consider the 1967 Arab oil episode ineffective, costly, and thus unsuccessful.

Or not. In reality, it depends on which war one refers to. The embargo that arose from the Six-Day War did not budge oil prices at all, while the Yom Kippur War’s aftermath released powerful shockwaves:

What set apart oil market reactions to a war triggered with an Israeli preemptive strike versus a war triggered with an Egyptian and Syrian surprise attack? Primarily, U.S. oil imports:

Sources: To calculate OAPEC´s export to the US and the data for Venezuela, Iran and Indonesia and total the US import the following sources were used: the US Energy Information Administration (EIA) Annual Energy Review 2009, Table 5.4 Petroleum Imports by Country of Origin” 1960-2009, U.S Census Bureau, Statistical Abstract of the US: Table No 856, 1960-1973, Table No 910, 1965-1975.

(1) OAPEC: includes: Bahrain, Iraq, Kuwait, Qatar, Saudi Arabia, United Arab Emirates, the Neutral Zone (between Kuwait and Saudi Arabia), Algeria and Libya.

Domestic American oil production peaked in 1970, which explains how oil imports more than doubled between 1967 and 1973…wait, no it doesn’t. Actual oil consumption increased by 40%…

Source: EIA, table 5.9 “Refinery Capacity and Utilization”, for consumption data: BP Statistical Review of World Energy 2010 “Oil Consumption”.

…and the U.S. was importing a significant quantity of volatile refined fuels:

As the European countries pointed out in the report by GAO in 1973, they were the ones that had to export refined oil (like gasoline) to the US because the US did not have enough refineries to process it autonomously. Now, looking at Table 3 above, one can clearly note how the US oil refineries are processing less of the US oil consumption each year. Even prior to and during the 1967 embargo the US had to import gasoline. Thus, US vulnerability to an oil disruption is clearly connected to its refining capacity. Had the US built more refineries before 1973-74, it would not have had to import gasoline or other refined oil products that were needed in Europe during the crisis as well. This becomes apparent when looking at the gap between the US oil demand and oil refining capacity in 1973. A simple conclusion is that the US could clearly have diminished its vulnerability to an oil disruption, particularly in 1973-74, by building more refineries instead of importing more oil.

The number of American oil refineries has decreased by more than half since the EIA began tracking output in 1982, and refining capacity is only now returning to the output the United States was able to refine 32 years ago despite crude oil prices quadrupling in the interim (at times increasing six-fold over prices that predominated during the 1980s and 1990s). The very first posting on this blog centered on the refinery conundrum, which apparently has persisted since at least 1973. But a full revisit of the oil market’s myriad failures will have to wait for another posting. Oil was but a small segment of the onrushing stagflation.

Price Control Failures

Let’s look at oil prices again:

Oil in 1973 diverged away from a stable, long-term price trend. Then again, prices for everything shot up starting in 1973:

1973 ushered in a period of very tight supplies in wheat and feed grains worldwide. In 1972, the U.S. had sold over 20 million metric tons of grain to the Soviet Union and dollar devaluations in December 1971 and again in February 1973 sharply stimulated export sales of other agricultural commodities. The [Nixon] Administration had anticipated some pressure on food prices during the first half of 1973 and had retained mandatory, though looser, controls over the food industry during Phase III. The results, however, were worse than even the most pessimistic predictions. During the first quarter of 1973, consumer food prices shot up at an annual rate of 29.8% while the wholesale price index for farm products rose at an annual rate of 51.9%. Red meat prices alone surged at an annual rate of 90% during the quarter.

The Council explained that the price increases reflected fundamental market forces: a combination of very strong consumer demand, unprecedented decline in supplies carried over from the previous year and expanded exports due to currency shifts and crop failures abroad. On March 29, 1973, in an abortive attempt to slow the onslaught, the Council slapped a freeze on red meat prices, but this step backfired as ranchers retaliated by withholding supplies and creating meat shortages. Meanwhile, other food prices continued their seemingly inexorable rise.

This 2011 tome by William N. Walker, Nixon’s Deputy Director of the White House Office of Consumer Affairs, describes how the October 1973 start of the second Arab Oil Embargo shredded the president’s best-laid plans:

Crude oil price postings had been virtually flat for many years as a result of chronic over-supply in world markets. In the twenty years 1949-1969, crude oil prices in the U.S. ranged between $2.54 and $2.94 per barrel and American consumers had come to assume that low prices for gasoline and other oil products were an inalienable birthright. But price stability ended as U.S. production declined and world demand surged. Phase IV regulations placed a ceiling on the price of domestic crude oil at $4.25 per barrel. It was the Council’s intent to increase this ceiling by about 25 cents every quarter so that by April 30, 1974, when the controls program was scheduled to expire, crude oil prices would be in the $5.00-$5.25 range, comparable to expected world price levels. Events were to prove these assumptions fatally wrong.

October 20, 1973 became known as the Saturday Night Massacre when Nixon fired Attorney General Elliot Richardson and Deputy Attorney General William Ruckelshaus for refusing to dismiss Archibald Cox as Watergate Special Prosecutor. It was a night of high drama and political intrigue in Washington. Only a handful of people paid attention to an item moving over the news ticker that same evening reporting that OPEC nations had doubled the price of their crude oil exports.

This action raised world crude oil prices to almost $7.00 per barrel, creating a huge spread above the U.S. ceiling price, fixed at $4.25, and causing major problems for the Phase IV rules. In early December, the Council raised the U.S. ceiling price $1.00 to $5.25 per barrel. The public was furious, Ralph Nader filed suit to set aside the increase, Congressional hearings were immediately called and the Council’s decision was attacked on all sides. The conventional wisdom at the time was that OPEC was weak and ineffectual. The public was therefore indignant that U.S. oil prices were being raised ‘just to pay off some desert sheiks.’

I need to reiterate that the OPEC nations weren’t being paid off. Instead, the embargo was in retaliation for Operation Nickel Grass, the massive U.S. Air Force Military Airlift Command C-5 and C-141 supply campaign that supported the IDF slaughter of Egyptian and Syrian servicemen in October 1973. Walker acknowledges the war but makes no mention of the MAC angle:

The public soon discovered just how badly they had miscalculated OPEC’s resolve and its leverage. In the wake of the Yom Kippur Arab-Israeli conflict, OPEC declared an embargo upon shipments of oil to the U.S. and other Western nations and, by the first quarter of 1974, in the greatest supply disruption the nation had ever experienced, American motorists were forced to endure long lines at the gas pump. To make matters worse, on the last day of December 1973, OPEC again doubled oil prices, to levels above $12.00 per barrel. The spread between the U.S. crude oil price ceiling and rising world prices increased. This created the need for a new “entitlements program” to ration low-cost, price-controlled U.S. crude oil among American refiners by forcing the domestic producers to transfer hundreds of millions of dollars to the refiners purchasing much higher priced foreign oil. This program lasted for several years until the crude oil price ceilings were finally scrapped and prices were allowed to find their equilibrium.

Perhaps, or it could be that the end to government intervention simply opened the door for commodities traders to brazenly manipulate crude oil prices. But this episode serves to show that the 1973 oil embargo did not trigger the spike in inflation—Phase III began in January 1973, and fell apart long before the Yom Kippur War commenced. Critically, the shattering of Nixon’s price control schemes wasn’t due to the wage-price spiral either:

What no one understood at the time was that economic conditions had undergone a profound and dramatic change. The cycle of wage-driven price hikes had been broken during Phase II. But government and private forecasters uniformly failed to recognize that demand had begun putting such severe pressure on supplies that within a matter of months, prices of virtually all commodities — food-stuffs, minerals and petroleum — would explode, reaching historic highs. The rate of inflation shot up to 11% by the summer of 1973, leaving Phase III in shambles.

Wait, did a conservative Nixon Administration official actually contradict the common assertion that wage-based price increases triggered stagflation after 1973? Yes, Walker did. Not to mention his attack against the wage-price spiral wasn’t a slip of the pen:

Whatever his reasoning may have been, Nixon went before the Nation and for the second time in less than two years imposed a freeze on prices. Wages were not to be frozen since wage settlements had not caused the inflationary price hikes of Phase III.

Nixon’s price controls totally failed—though that wasn’t the only set of price controls that failed utterly. Once wartime ended, the prices of most commodities climbed skyward (as they tend to do amidst demobilizations) and triggered high rates of inflation. The 1973 failure was presaged by the breaking of the longest-running price controls in world history.

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4 thoughts on “Aggregate Demand Dominance: Price Controls’ Nemesis—Oil Embargoes and the Onset of Stagflation

  1. Pingback: Aggregate Demand Dominance: The Arc Lights and the Ides of March | In The Corner, Mumbling and Drooling

  2. Pingback: Aggregate Demand Dominance: False Foundations | In The Corner, Mumbling and Drooling

  3. Pingback: Aggregate Demand Dominance: Reaping the Whirlwind | In The Corner, Mumbling and Drooling

  4. Pingback: The Wrong Turn | In The Corner, Mumbling and Drooling

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