It’s not merely the political Left that wants to intervene into the marketplace. Even some otherwise clearheaded individuals have fallen for the argument that “energy independence” is necessary on “national security” grounds, or because we are “transferring wealth” to Middle Eastern terrorists. The same arguments against intervention by liberals, however, are no less valid here. They’re actually even more persuasive because it is a matter of national security.

T. Boone Pickens, in his efforts to validate (and obtain government money - “ensure [his voice] will be heard by the next administration” - for) his huge natural gas holdings and recent $2 billion investment in wind turbines technology, argues that we are “transferring wealth” out of the country and it’s “crushing our economy”. Nothing could be further from the truth. When you go to the store to buy a loaf of bread, you aren’t “transferring wealth” to the grocer. He already owns the bread. You exchange money for product because you value the bread more than you do keeping the money. This is true for any purchase even if the seller happens to live overseas or is otherwise engaged in unsavory activities. Oil producers already own the oil, a valuable commodity for which there is worldwide demand. That oil is purchased for consumption in this country means that some American is willing to pay more (marginally) for that next unit of oil than a comparable consumer in Europe or China. From the perspective of the consumer, the source of the commodity makes no difference.

The reason so much oil is imported to the United States is that demand has outstripped domestic production because of the relative strength of the US economy. Consider that the only countries coming close to meeting their Kyoto targets are those of the former Soviet Union whose demand for oil dropped precipitously when their economies collapsed (conveniently after the base year set in the Protocol, but that’s another issue).  We import oil because other countries have a comparative advantage producing oil. We can therefore buy it from them at a lower price than at which we can currently produce it ourselves. The resources we would otherwise have expended on greater oil production are invested in more productive endeavors.

If the market operated normally, that would be the end of it (excepting the national security concerns addressed below). Unfortunately, the government has chosen to interfere by placing constraints upon production, primarily in ANWR and the continental shelves. It is abundantly clear that there is ample interest in developing these resources, which would both increase production (reducing prices to a level below what they would otherwise be) and inject the return for such investments into the American economy. Make no mistake: cost effective development of available resources yields a huge benefit to the US economy and would increase, perhaps substantially, the percentage of US energy consumption that is produced domestically … but that’s not the same thing as energy independence.

Understand: a societal goal of “energy independence” requires nothing less than government intervention to prevent the use of foreign oil (or even some other energy resource) even when it is economically beneficial to do so. In order to justify such an action, one must demonstrate that the benefits of independence are at least marginally greater than the costs. They are not.

The alleged benefits of an energy independence policy are usually expressed two-fold. First is the benefit of favoring the American producer and second is eliminating the national security risk associated with reliance upon foreign producers for a product considered vital to the economy. The first “benefit” simply doesn’t exist. Again, in the absence of government interference, American producers will deliver the optimal amount of oil (as determined by the interaction of supply and demand). Government intervention to either increase domestic production or inhibit domestic consumption yields economic inefficiencies and incents malinestment in otherwise too-costly endeavors that harm the economy rather than helping it.

That leaves the national security argument: What if a hostile nation (or nations) upon which we depend for oil chose to cut us off? How much damage would that do? How would our military function without oil for tanks and planes? Shouldn’t we eliminate that risk? In a word: no. The risk is largely imaginary. Neither the nature of US imports nor the functioning of the marketplace would allow such a crisis to manifest itself.

To understand the scope of the potential crisis, one must examine how much (or how little) of our oil consumption is subject to disruption by any single entity or group. According to the Department of Energy (source for each of the figures referenced), in 2007, the US consumed 7.55 billion barrels of crude oil and petroleum products. Almost exactly 35% of that amount was produced domestically, meaning that 65% (4.91 billion barrels) of our consumption was supplied by imports (alarmist rhetoric always rounds in such a way as to make things sound as dire as possible which is why we hear that we rely on imports for “nearly 70%” of our consumption).

The largest exporters of oil to the US are not from the Middle East. Canada, which sends us more than the entire Persian Gulf combined, and Mexico together exported 1.45 billion barrels to the US last year (19.1% of consumption). Another 1.28 billion barrels (16.9%) were provided by other non-OPEC sources. All told, this accounts for 71% of US oil consumption, which, of course, leaves OPEC.

Is that production is at risk? Not really. OPEC is a cartel created to restrict supply in order to increase revenues for member countries (and even that hasn’t worked). To exclude a potential customer from the market – particularly the largest customer – would work directly against that goal. Moreover, and this is the most important point, unless the country or countries wishing to stop supplying the US ceases production entirely, all that happens is that oil that would otherwise have come to the US is purchased by consumers in other countries and US consumers purchase the oil those other buyers would otherwise have gotten elsewhere. Excluding a relatively short term market adjustment period, the ultimate net impact would be negligible.

If either Saudi Arabia or Venezuela, the next two largest suppliers after Mexico, each supplying about 7% of US consumption, cut us off, we would simply purchase more from Russia or Norway or some mix of the other 95-odd countries from which we purchased oil in just the last year alone. In the interim, we’d tap the Strategic Petroleum Reserve, which holds about 16% of annual production (more, by far, than is necessary). By restricting consumption of foreign oil by governmental fiat (or tax or subsidy, which amounts to the same thing) we incur all the harm of such a cut-off while abandoning the option of seeking another supply source. If we don’t want others to do this to us, why should we do it to ourselves?

I long ago ceased being surprised by the sheer number of people – particularly politicians whose grasp of basic economics rarely gets beyond the ads for X-ray specs and sea monkeys in the back of their Archie comics - who opine with absolute certainty that current conditions could not possibly be “normal” and that prices/wages/supply/demand are either being manipulated by sinister (translated: non-governmental) forces or must be “market failure”.  That so-called “market failure” is inevitably an example of governmental failure is a topic for another day.  For now, let’s deal with the wrongheaded notion that we don’t need to address oil supply issues because the price is only being inflated by those dastardly “speculators”.

Contrary to popular belief, speculators provide a very real and valuable service to the economy.  First of all, by creating a market for futures contracts, the speculator takes on the price risk of the supplier ensuring that the end price warrants the initial investment.  In agricultural products in particular, this transfer of risk ensures that supplies will be higher because farmers need not worry about a potential price collapse that might dissuade them from planting.  Second, the speculator – at the risk of his own resources – removes product from supply during one period in anticipation of greater demand in some later period.  If he has speculated correctly, he will make a profit.  The short term impact is that the reduced supply raises short term prices, but eventually, the speculator must return the product to aggregate supply, reducing prices to a level below what they would otherwise be at that later date.  Thus, the speculator stabilizes overall supply and significantly reduces price volatility.  That oil prices still appear to be quite volatile is not an indication that speculators do not perform this function but, rather, is an indication of just how little impact speculators have on oil prices.

How can this be?  After all, back in May, Michael Masters of Masters Capital Management, LLC gave spectacular testimony before the Senate Committee on Homeland Security and Governmental Affairs demanding that the practice of “index speculation” be banned because of the massive impact on the price of oil that results.  Alas, the only thing truly spectacular about this testimony is the magnitude of the errors in the supposed analysis.

Note that, in the scenario mentioned above, the average price of the commodity over time remains completely unchanged.  All other things being equal, the impact of speculation is that the price of the commodity rises earlier by a given amount and is reduced at a later time by a like amount.  The ultimate price of the commodity is still determined in its entirety by supply and demand.  How is that different in the oil futures market?  It isn’t.  In fact, it is even less likely that speculators in the oil futures market can materially impact price than in any number of other commodity markets.

Say you choose to invest in gold.  This is a common practice and many people own shares in “inflation hedge” instruments.  As an individual investor, you can actually remove from circulation an amount of gold and place it in a vault somewhere.  So long as that gold is locked away, the available supply is reduced by a like amount.  At the same time, the investor gains no return on that investment until such time as he returns it to the marketplace.  There is still ultimately no impact on the long term average price (again, all other things being equal), but the time horizon is such that it may be several years before the return to circulation of that commodity impacts the market price.

With oil, such a scenario is essentially unheard of.  None of the speculators in the marketplace are actually taking ownership of Texas tea no matter how sweet the crude might be.  The only players in the marketplace actually removing significant quantities of product from the market are government entities.  The US government has socked away 705 million barrels of in the Strategic Petroleum Reserve.  Japan has the second largest reserve with a capacity of nearly 580 million barrels.  All that is being traded in the futures markets is the ownership of a commodity to be delivered on a specific date.  Thus, when the illustrious Mr. Masters uses the wheat futures market as an example of speculators run amok and tells us, “the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!” he is neglecting the obvious fact that no actual wheat is owned by such speculators at all.  For that matter, just how likely is it that speculators would remove wheat from the marketplace, presumably until it spoils, guaranteeing a loss of their investment?  The whole premise is absurd.

Oil futures contracts can go out years but the reality is that the trading of such contracts is overwhelmingly concentrated in the short term.  More than 90% of trading today (July 14) in oil futures contracts is concentrated in those due for redemption within the current year.  Further, when Mr. Masters breathlessly announces that index speculators “roll their positions by buying calendar spreads. They never sell (emphasis in original)”, he is misstating the fact that such rollover activities exchange one short-term contract for another and represents a sale in and of itself.  Still no change in the supply or consumption of oil takes place.

Finally, to get a handle on just how much of an impact speculators have on the oil market as a whole, consider:

Much has been made of the increase in the futures market.  To stick with the figures used in congressional testimony, the amount of unrefined oil traded on the futures market jumped from 147 million barrels (1/1/03) to 830 million barrels (3/12/08), a 465% increase.  But to assess the magnitude of such an investment, one must compare it not to the supply of oil from a single supply source over some short delivery period, but to the global marketplace over the total long term period of production.  Current world oil production exceeds 86 million barrels per day so the amount traded in the futures markets amounts to a no more than 2.6% of annual production, but, again, that’s just the production within a single year.  If you consider that nearly 277 billion barrels of oil were produced worldwide over the decade ending in 2005, the impact of speculation on long term oil prices can be put into real perspective.  So much for the theory that $40-$70/bbl of the current price is due to speculation.

The story goes that it is “unfair” that the oil companies are “gouging” consumers at the pump while reaping record profits. As one reporter argued, “If ExxonMobil were a country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank’s economic rankings.” The oil industry argues that looking at nominal profits is meaningless. What matters, they say, is profit margin, which is materially lower for oil companies than for other major industries. Recently, a third view has surfaced – in no small part as a response to the oil company position - asserting that the key measure is return on equity and “the oil industry as a whole earned a 27 return on equity [in 2007] and that this was 10 points higher than other industries”. Whose view is correct?

Let’s take them one at a time. As one might expect, it is the position taken by the politicians that is completely wrong. As has been made clear in countless articles and columns by competent analysts and economists, looking at nominal profits in a vacuum is of no value whatsoever in assessing the real profitability of a company or industry. I will not rehash the reasoning behind this obvious point here.

Naturally, this means that the oil companies have a much more tenable position when they argue that profit margins examine profitability in context. The oil industry earned about 7.6% of revenues in the fourth quarter of 2007. For comparison purposes, all of US manufacturing (excluding auto manufacturing which took a dive as gas prices rose) earned approximately 9.2% of revenues in the same quarter. These are figures concede even by the industry’s detractors.

One must be careful when looking at such numbers. One quarter does not a trend make and there are those on both sides who will point at specific industries who performed better or worse (depending upon the point of view) in order to make a point. The banking industry, for example, has taken a bath since then (roughly since I took up my current position with a regional bank), but banking has long been an industry that generates higher margins than the average. That’s the point: over the long haul, the oil industry earns profit margins generally lower than most other industries, including other manufacturing industries.

But the response to the emphasis on profit margins – that return on equity (ROE) is a viable indicator of company profitability – has some merit. The question is whether or not such a measure is materially superior to a comparison of profit margins and, further, whether or not such a measurement can indicate whether or not the industry has reaped a “windfall”. The answer to both questions is: no.

First of all, while the dismissal of nominal profits as unrelated to underlying investment has merit, the dismissal of profit margin on the same grounds does not. While looking at nominal revenue growth would be equally useless, the profit margin, by extension, reflects the outlay (expenses) necessary to generate those profits. While expense outlays are a step removed from shareholder investment, the connection between spending and profits is far more immediate than between capital holdings and earnings in any particular period.

Nor is the use of ROE as a measure without problems. One must remember that these are accounting measures that are designed to represent, as well as possible, real world conditions. Understanding those real world conditions is so important that literally dozens of alternative measures have been developed to refine the concept (ROA, ROCE, ROGIC, RAROC, etc.).

Then, of course is the (deliberate) distortions in the use of these measures. The statement about the oil industry being “10 points above” all other industries is factually wrong. For the period (a point I’ll come back to), the oil industry’s return was 10 points higher than all other manufacturing industries. Further, the manufacturing figure included the automotive industry whose returns were so poor during the quarter that its losses depressed the profit margins for the entire US manufacturing sector from the 9.2% mentioned above to a mere 5.8%.

The argument is then made that these ROE figures have been higher during the period of rising prices, just as they were when prices rose in the early 1980s. Rather than demonstrating a “windfall”, however, this merely demonstrates a material flaw in using ROE as measure of assessing profitability over the short run. It should hardly come as a surprise to anyone that periods of rapidly rising prices can easily outstrip the pace at which a company can attract capital. The differential is not some wonderful bonus for the company but an indication of how much more a company must spend to acquire additional capital. That is, because funds must be obtained more rapidly in comparison to other investment alternatives, a premium must be paid to investors to attract needed capital away from those alternatives. Such conditions are particularly prevalent in industries that a particularly capital intensive – and you’d be hard pressed to find many more so than the oil industry – and have historically low profit margins because thinner margins mean greater investment risk.

In the final analysis, higher returns on equity during a period when costs, and thus dependent prices, are rising rapidly are not evidence of a windfall, but nothing less than an informed observer should expect.

In such an environment, assessing a windfall profits tax is particularly foolhardy. Not only is it attempting to recoup a benefit that does not exist – and “recoup” is a further misnomer as there is never any intent to return it to those consumers supposedly harmed when it can, instead, simply be added to the public treasury to buy still further votes – but it reduced capital in an industry that, for reasons that should now be obvious, is in desperate need of additional capital to finance the greater expense burden. The inevitable result of such a move is to increase the cost of funds to the industry and place further upward pressure on prices and downward pressure on production. The results of the original “windfall profits tax” signed by Jimmy Carter was no fluke. Prices surged still further and the problem was simply made worse.

It was up to Ronald Reagan, who as his first official act deregulated oil prices, to return sanity to the energy market and allow prices to fall to the point that the real price of a gallon of gas didn’t return to similar levels for more than a quarter century.

Desperate attempts to avoid responsible action with regard to energy production have yielded a bumper crop of responses that can only be described as monumentally stupid. They include: a) it will take [fill in excessive number here] years to achieve results, b) funding of alternative energy research will solve the problem, c) there is all this untapped oil in land already leased to oil companies, d) oil profits are excessive and a windfall profits tax will help consumers, e) it’s not lack of production, companies conspired to reduce refining capacity, f) it’s all the fault of “speculators”… and there’s a whole host of other less hare-brained but still wrongheaded positions including the need for “energy independence” or the notion that building refineries on closed military bases will provide significant help.

For now, let’s look at the idiocy that would have you believe that you are suffering at the pump because oil companies conspired to eliminate refining capacity. This one deserves particular scrutiny because we being assured that there is indisputable proof of the misdeeds of oil executives in the form of incriminating memos. In reality, the smoking gun is nothing more than a water pistol … a small one … oh, and it’s broken.

One should always be skeptical of assertions that an individual or a group of individuals is acting against their own interests. Sure, it happens all the time (see support for Obama), but never when they actually perceive the harm they are doing themselves, but when we are expected to believe that established businessmen, as a group, are foregoing a chance at earning money because they have the opportunity to stick it to the consumer, it should set off serious alarm bells.

Before getting to the “proof”, let’s take a moment to examine the reason this excuse for inaction has been trotted out in the first place. Is it the cost of refining or a lack of refining capacity that’s behind the precipitous climb in the price at the pump? Is there a legitimate argument to be made that, before considering drilling offshore or in ANWR as solutions, we should address the increased price of gas attributable to the refining process? Not a chance.

Consider, according to Department of Energy’s assessment of gasoline costs, the chief driver of gasoline prices is – wait for it! – crude oil. In the late 1990s, the price of crude, while still the chief component of the pain at the pump represented less than 40% of the total. By 2001, with the average price per gallon at $1.42, crude oil accounted for only 38% of the price at the pump (54 cents). Taxes accounted for another 30% (42 cents). Marketing, distribution and other overhead – excluding refining – accounted for another 14% (20 cents). The cost of refining, already beginning to rise not so much due to a reduction in overall capacity but because of the ever more varied environmentally friendly fuel mixtures in each and every state (and the introduction of ethanol to gasoline was only just beginning), accounted for 18% (26 cents) of the total.

The world has changed radically since then. By 2002, the percentage of the price attributable to the underlying crude had risen to 43%; by 2004: 47%; by 2005: 53%. By 2007, with the average cost of a regular gas at $2.80 per gallon, the percentage of it attributable to the cost of crude oil had risen to 58% or $1.62. Taxes remained unchanged at 42 cents so, as the price of gas doubled, the percentage attributable to taxes halved to 15%. Marketing and distribution costs fell to 10% of the total or 28 cents (the nominal increase of 8 cents per gallon in no small part due to the cost of transporting the fuel to your local gas station).

Refining accounted for 17% or 48 cents of the total. The percentage was down and, again, the nominal increase was due to the increasing cost of new refining requirements demanded by environmental regulations, which now include not just grades of the gas itself but the inclusion of varying levels of ethanol. Nationally more than half the gasoline sold contains some level of ethanol. In Hawaii, it is more than 85%. California increased the required amounts of ethanol in 2007.

Now, of course, at a time when, we can fondly remember gas at a mere $2.80 per gallon, the uselessness of blaming refineries is even more obvious. The price of gas has risen to an average in excess of $4.00 per gallon and that jump is due entirely to the cost of crude, which has soared from an average of about $68 per barrel to nearly $118 per barrel. Now, crude represents in excess of 70% of the price paid at the pump. That’s right, campers, you’re paying more just for the crude now than you paid for the finished product in 2007! Can it reasonably be argued that the problem is the cost of refining, which now represents less than 13% of the total cost?

So, what about the plot to harm consumers? Congressional investigations (sic) uncovered internal memos from Texaco and Chevron arguing that margins in the worldwide refining business were extremely tight and that a “surplus refining capacity” existed undermining the viability of the business. In each case, the internal memos argued that reduced excess capacity, either via plant closures or increasing relative demand, was the only way to improve margins. Hmmmm. Well, the only response I have to that is: “DUH!”

All the memos “prove” is that the authors had a grasp of reality at a time, in the mid 1990s, when there was excess capacity. In fact, every industry is economically driven to reduce excess capacity as much as possible (which moves resources into more productive avenues to everyone’s benefit, but I digress).

Meanwhile, the margins in the refining industry – and it must be remembered that businesses do not (and cannot be expected to) deliberately lose money on some segment of their business because another segment can offset the loss – were so thin that it was impossible to attract investment capital. This is not a new phenomenon. Margins in that sector have always been thin and, according to Cambridge Energy Research Associates (CERA) data, the costs, worldwide, of refinery construction have been rising steadily and at an ever increasing pace.

What happened is that unprofitable (and largely old, difficult to convert) refinery facilities were shut down at a time when insufficient capacity was not the problem it is today and the prohibitive cost, regulatory nightmare and continued animosity of the legislative powers that be have made attempting to opening new ones an enormous risk. Instead, investments were made in existing facilities and refining capacity has steadily increased (up more than 15% since 1993).

The allegation is nothing more than a lie. And last time, I checked, business executives responding rationally to market conditions – eliminating excess capacity and expanding existing plants as necessary – is proof of nothing more than intelligence … obviously lacking in the accusers.

Just a few thoughts that have struck me on a variety of issues…

f Among my least favorite words in the English language may now be added the term “relapse”. The unfortunate reality is that the caprices of the human mind and body sometimes outstrip the capabilities of modern science. At the same time, I never cease to be amazed at the phenomenal array of substances that modern science and private industry have developed to address the frailties of the human condition.

f Yet again I am infinitely grateful that this country has withstood the demands for universal healthcare. In the last couple of months, I somehow managed to blow out the rotator cuff in my left shoulder, making such tasks as typing a painful chore, and my daughter was diagnosed with a rapidly growing fibrous mass in one of her breasts. I was able to get an X-ray even before leaving the building after seeing my doctor and, when that did not detect the problem, got an MRI (which apparently stands for “Must Re-harm the Injury”, but I digress) not long after. My daughter got a mammogram and had the mass (benign, thank God) removed in short order. Neither of us experienced the long waits for diagnostic and surgical treatment that are the norm in countries with socialized medicine. Consider, for example, the case of Jennifer Bell, a 22-year old English woman who died waiting the necessary 13 weeks for a “relatively urgent” MRI.

f Never forget the law of unintended consequences. The governmental response to the economy has been eminently predictable. First, it – specifically the Fed - caused the problem by pumping vast amounts of excess liquidity into the marketplace by holding interest rates well below the historical cost of capital. Once these funds had been dispersed – malinvested – throughout the economy, primarily in the form of mortgages, the problem was exacerbated by the Fed (again), which raised interest rates above the historical cost of capital. For those keeping score at home, this is exactly the type of behavior, albeit at a much greater scale, that caused the Great Depression.

But wait, there’s more! The Federal government responded – as it typically does – with a whole series of completely wrongheaded “solutions”. First, it responded by shooting the nearest bystander – the lending industry, based upon the brilliant theory that an entire industry – or at least a large part of it - would go out of its way to place its own resources at risk in such a way as to cause more foreclosures and inevitably lose them large sums of money. Second, it put forth a stimulus (sic) package based on the long debunked theory of the benefits of feeding “aggregate demand” which, of course, is really just another increase in governmental spending (which is the real problem). Third, it has chosen to place significantly more power in the hands of the Fed.

Oh, and as a side note, one of the impacts of the sudden infusion of stimulus checks into bank accounts is a sudden reduction in fee income to the banking industry (in the several billions) reducing the amount of capital available to banks at a time adequately described as a “credit crunch”. Brilliant.

f Along the same lines, the Center for Responsible (sic) Lending (CRL) has convinced the Fed to crack down on “abusive overdraft loans”. Actually, when the Fed is hit from the political side (i.e., Barney Frank) to address some “injustice” in the banking industry, it sends out proposals in the hopes that member banks will either solve the problem or give it sufficient justification for foregoing some action. This particular proposal was embedded in a proposal sold as a means to curtail abuses in the credit card industry (which politically, of course, cannot be ignored no matter who else is really affected by the fine print).

What’s “abusive”? Well, in the event that the bank chooses to accept the financial risk and actually pay the item that overdrafted the account, the CRL has decided that the overdraft fee – a fee that would be assessed even if the item were not paid and Joe Accountholder’s mortgage didn’t get paid – is really an interest charge. The unintended consequence is that, during a “credit crunch”, either $15.8 billion of funds made available to account holders will vanish or billions of dollars in bank fees will be removed from banking capital or, more realistically, both because a “consumer advocacy” organization has completely mischaracterized an issue. Who could possibly have seen that coming?

f It seems I am forever defending the “bad guys”: employers, lenders, oil companies, pharmaceutical companies, and more. I am vigorous in my defense of bar owners to do what they will with their property, including *gasp* accommodate smokers. I am unwavering in my condemnation of courts that interfere with the rights of homosexual couples to do what they will with their property including disposing of that property exactly as they might if they were a married heterosexual couple. At the same time, I will continue to make the argument that even the most unsavory bigot that doesn’t wish to cater to anyone but WASP males (a group to which I am not a member) should be permitted to exclude from the use of his property anyone he damn well pleases. I wouldn’t want to associate with such an individual, but that is not the point. I am unyielding in my defense of the free speech rights of radio stations who wish to – perish the thought – determine their own content.

Put simply, I trust the property rights of the individual with the most outrageous of thieves before I trust them to the average politician. The thief can typically only harm a relatively small group of people at a time and he typically doesn’t pretend that he’s fleecing you in your own interest when he does it or, worse, pretend that such is the case even after he has been caught robbing you blind.

f My father-in-law, an Old World, inner city, union, government worker for decades until he retired gentleman with whom I simply do not discuss economics or politics in the name of family amity, recently demanded, “How can gas stations raise the price on what they already have in the tank? It’s the same gas?!” I didn’t answer for reasons already mentioned, but I might have asked, “How can you sell your house for more than you bought it for 20 years ago? It’s the same house.” Of course, it would cost more to buy the next house, too. Well, any business that does not take into account the replacement cost of its inventory is doomed to failure and then those bad guys who do nothing but take you to the cleaners are no longer there to take your money … or, for that matter, provide access to the means to power your vehicles.

Entrepreneurs drive the economy; so what is the role of consumers?  Put simply, they are judge, jury … and executioner.

Consumers represent the ultimate democracy of the marketplace.  They decide who succeeds (and by how much) and who fails.  They determine what products are most urgently needed and what goods are either unwanted at the moment or unwanted at a price that can be provided at any given time.  The sovereign consumers decide whether or not the actions of entrepreneurs result in profit or loss.

In an odd paradox, there is a common misconception in modern liberal thought that, at the same time, both embraces and denies this simple truth.  On the one hand, it is believed that consumers drive the economy and that interfering in the economy to place ever more resources into the hands of the consumer can solve all economic ills.  On the other, modern liberalism embraces any number of interventions that pretend that the consumer simply cannot be trusted with this power.

The entrepreneur acts first, but he must do so with an eye toward meeting the demands of the consumer.  If he undertakes any action that fails to meet consumer needs to the greatest extent and at the lowest possible price, the consumers will exercise their power to penalize him.  They will seek out the products of a competitor, attempt to locate substitute goods that will meet their most urgent needs in another way or they will ignore the producers’ goods to an extent that will put such enterprises out of business.

In such an environment, the entrepreneur who wishes to survive the judgment of consumers cannot engage in “price gouging” because, in a marketplace unrestricted by government, there will always be another means of meeting those customer demands.  In such an environment, the entrepreneur cannot incur costs that make his products less competitive with those of other producers.  Taken to its logical conclusion, it is the consumer that imposes restrictions upon producers that prevent them from paying above market prices for any resource – capital, material resources … or labor.  In that sense, it is the sovereign consumer that determines not only the level of wages that can be paid in the marketplace, but even whether or not the producer must consider seeking labor from (foreign) markets where the costs are materially lower.

The mandate of the consumer is ultimately inviolable and yet it is contradictorily believed that unpopular actions – primarily with regard to the employment of labor – are undertaken arbitrarily and either maliciously or without care for the consequences.

The same sort of disconnect takes place when someone demands intervention in the marketplace to manipulate prices.  In each and every case, the consumer is deemed incapable of setting the “correct” price and, as a result, the state must artificially manipulate prices to achieve some “better” result.  Part of this disconnect comes from the misguided belief that producers set prices in a vacuum, but, again, in the rare exception of monopoly – which I’ll touch upon in a moment, consumers will not permit such “gouging” to take place.  In reality, the justification for manipulating prices, is that the state (or, in the case of debate, the individual demanding such intervention) has asserted that their wisdom is superior to that of the free choices of individual consumers.  It makes no difference whether the intervention is to keep prices higher, to keep them lower or even, as was disastrously demonstrated during the Roosevelt years, both at the same time.

Interestingly, the former case is the most prevalent.  Consumers, we are told, should simply pay more for some products than they would in a truly free market.  If we let consumers do what they wish, they might not want to pay enough to support the least efficient producers in the agricultural sector, putting farmers out of work.  They might purchase items from abroad rather than patronizing domestic business to a significantly greater extent.  They may even – hold onto yourself – choose to buy alcoholic beverages, cigarettes or gasoline in greater quantities than our benevolent leaders would like.

It must be remembered that the manipulation of prices invariably harms everyone.  Protecting the least efficient farmers, for example, not only forces the consumer to pay more for produce, making those resources unavailable for use elsewhere, but it subsidizes inefficiency preventing the marketplace from allocating those resources to more useful endeavors that generate more products and more jobs.  When the Bush administration intervened to “protect” steel workers in the US, prices were artificially inflated.  This not only prevented the steel industry from adapting more quickly to market forces – again, subsidizing inefficiency and destroying capital – but it was a devastating blow to those industries that use finished steel.  The net result was that even more jobs were lost in those industries than were “saved” – however, briefly – by the manipulation of steel prices even for a relatively short period.  The deleterious consequences of efforts to inflate prices invariably cause more harm than any perceived benefit from their implementation, often yielding the exact opposite of the stated objective.

In the latter case, it is asserted that consumers should not be required to pay market prices for “necessary” commodities.  In such circumstances, the state either intervenes by imposing price ceilings or by substituting state control for the function of producers.  [Note: The choice not to use the word “entrepreneur” here is deliberate.  The entrepreneurial function that drives the economy requires responsiveness to the market.  State control of production renders such responsiveness impossible.]

But in the case of price ceilings we know the inevitable result is shortages, often in unexpected ways.  Rent control, for example, has simultaneously reduced the availability of rental units – affordable or otherwise – and created slumlords: property owners whose revenue stream has been curtailed by rent control so, rather than responding to the needs of consumers, fail to maintain minimum standards in their buildings.  Government run enterprises have, without exception, proven to be vastly inferior to private sector enterprises, typically running losses that must be covered by taxpayers while providing less than optimal service.  The postal service is just one such example.

Along these lines is the intervention to attack market monopolies.  The vast majority of monopolies arise out of governmental regulation: legal barriers to entry or preferential treatment but, occasionally, monopolies or near-monopolies arise in the marketplace because one provider of goods or services better meets consumer needs better than any other provider.  Classic examples include Standard Oil and Microsoft.  The chief complaint about monopolists is that they can charge consumers higher prices, but that happened in neither case.  Through Standard Oil’s greater efficiency and better refining techniques, the price of oil and kerosene fell significantly for consumers.  Likewise, Microsoft’s decision to bundle certain software items resulted in lower prices for consumers.  The intervention by the state in each case harmed consumers.

Consumers always do a better job of allocating resources than any central authority ever could.  This is why those economies engaging in such socialistic measures to a greater extent lag economically behind those that embrace free market capitalism.  When the government says it must do something about prices, overruling the power of consumers, it is consumers who must ultimately pay the price.

[Originally published February 26, 2007]

Once upon a time, the world “liberal”, in ideological parlance, meant defender of individual liberty.  Now, often as not, it means advocating the taking from one individual to give it to another.  For a number of years now, I have been making the argument that modern liberals have failed to grasp the simple distinction between “freedom” and “means”.  This confusion has led to the creation of oxymoronic phrases like “wage slave” and, in the context that liberals use the term, “economic justice”.

The distinction should be relatively simple.  Freedom is the absence of external constraint.  If you are prevented by an external agency (i.e., the state) from engaging in some activity, then your freedom has been infringed upon.  If you are prevented from engaging in essentially any activity by that external agency, you are a slave.  If, on the other hand, you lack the resources or abilities to engage in some activity, your freedom has been impaired in no way, whatsoever.  I lack the ability to simply soar into the air on my own power or the resources to purchase a Boeing 707 but there is no external agency preventing me from doing these things if the means were available to me.

Sadly, liberals frequently fall back on the nonsensical argument that employers restrict the freedom of the workers by not paying them enough – as if, in the real world, people lacked the power to seek employment elsewhere – so the state is justified in ensuring that everyone is given a certain level of means by taking it from others – infringing upon their economic liberty.  So, this time, I’d like to tray a new tack.  I’d like to demonstrate how the surest way for as many people as possible to acquire the means, is to give them the greatest possible economic liberty.

Arguments about how the chief reason for the prosperity and economic superiority in the world of the United States is overwhelmingly due to the relatively greater level of economic freedom tend to fall on deaf liberal ears.  Some, such as columnist Paul Krugman, perform truly amazing feats of statistical manipulation in order to make it appear that the more socialist economies of Europe are doing better than we are despite the evidence.  It’s dishonest, but there’s a market for people who will tell liberals what they want to hear.

So let’s set aside the US performance for the nonce and look at some examples elsewhere in the world.  Using the annual Index of Economic Freedom (IEF) and inspiration from an individual who posts using the nom du guerre, UncaAlby, I have selected a few sets of countries whose geographical location, population type and resources are relatively similar, while their levels of economic freedom are markedly different.  Using data readily available from the CIA World Factbook, let’s look at these sets and see if we can determine whether or not economic freedom does a better job of providing the economic means to the populace or whether the liberals are correct and that government intervention into the economy actually benefits the citizenry.

North and South Korea:  A greater example of economic disparity is hard to come by.  Unsurprisingly the IEF gives South Korea a score of 68.6; North Korea scored a 3.0.

A once unified people living on the same southeast Asian peninsula have the most disparate living conditions imaginable.  South Korea’s standard of living, as measured by GDP per capita, is thirteen times that of its poorer neighbor.  South Korea’s unemployment rate is only 3.7%; North Korea’s employment rate is only 10%, roughly the same percentage of the population not living in poverty.  South Korea’s economy is growing four times faster; North Korea’s inflation rate is nearly four times higher.

Botswana and Zimbabwe:  These two adjacent African countries also have similar peoples and resources.  The chief difference is that Botswana mining concentrates in diamonds and Zimbabwe has far more mining in ferrous and non-ferrous metals.  Botswana is half again as large as its neighbor to the west, but much of the country’s land mass is consumed by the desolation of the Kalahari Desert.  Botswana’s economy, however, is markedly less encumbered by the state.  The IEF gives Botswana a score of 68.4; Zimbabwe’s is half that at 35.8.

Botswana’s standard of living is five times higher than that of Zimbabwe’s.  Zimbabwe’s unemployment rate has reached 80%; Botswana’s is currently 23.8%, less than a third of their neighbor’s.  Botswana’s economy is growing by 5.5%; Zimbabwe’s is shrinking by 7.7%.  Botswana’s inflation rate is high at 8.6%; Zimbabwe’s is devastating at 266.8%.

Israel, the West Bank and the Gaza Strip:  Here there is admittedly a distinct difference in the peoples under discussion and the size of the territories involved.  However, it is still a relevant comparison given that the economic conditions of the peoples that occupied these lands for the extended period ending roughly six decades ago had not been so different by any stretch of the imagination than they are today, particularly in the West Bank.  Certainly, a significant factor in the economic disparity between the peoples is due to the internecine conflicts that have continued nearly unabated for the entire period.  But it is my contention that the economic disparity is in large part due to the relative levels of economic freedom and that the disparity is a significant driver of the conflict itself.

The IEF gives Israel an economic freedom score of 68.4 – coincidentally the same score as Botswana and almost the same as South Korea; Both the West Bank and Gaza Strip score a 3.0 – the same as North Korea.  The standard of living difference is astounding.  The average standard of living in the Palestinian territories is a mere $660 per year; Israel’s comes in at $24,700, more than 37 times higher.  Unemployment in Israel is running at 9%; it’s about 20% in the territories.  And inflation in Israel is running at only 1.3% vs. 7% in the territories.

Taken together, in comparison to the more economically free countries listed, the more economically repressed countries have a standard of living a mere one-thirteenth as high, an unemployment rate that is 16 times higher, a poverty rate five times higher, and an inflation rate 40 times higher.

Another example not included because of the vast population disparity is China vs. Hong Kong and Taiwan.  Again, the peoples are overwhelmingly similar.  It is the economic system that is different.  China scored a 54.0 from the IEF, indicative of some opening that has occurred; Hong Kong and Taiwan scored 89.3 and 71.1, respectively.  China’s standard of living: $6,760; Hong Kong’s: $33,760; Taiwan’s: $27,350.  China’s unemployment: 9.0%; Hong Kong’s: 5.5%; Taiwan’s: 4.1%.

The conclusion is inescapable.  While freedom and means are two entirely distinct concepts, the best way to assure that the means are available to the widest number of people is to promote economic freedom and the surest way to guarantee that as few people as possible have the means available is to espouse the same socialist nonsense that has become the staple of modern liberalism.

The question has been one of the main drivers of economic thought for centuries.  And for centuries, governments have been getting the answer completely wrong and then undertaking actions that were ultimately detrimental.

Initially, it was believed that economic growth was a myth – that it was impossible for any one actor in the marketplace to experience a gain (profit) unless some other actor in the marketplace experienced a corresponding loss.  This misconception has been the basis for wrong-headed economic policies for hundreds of years.  It was, in fact, the basis for the non-capitalistic construction of mercantilism so completely exploded by Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations”.

Sadly, this gross misperception refuses to die.  It is the cornerstone of beliefs behind modern protectionism, many variants of Christian socialism and the all-too-common fable that the wealth of the capitalistic West is nothing more than the stolen plunder of the third world at the expense of exploited workers.  That basic mathematics demonstrates such a conclusion to be absurd is merely written off as “capitalist propaganda”.  But simple logic demonstrates that the doctor who sets a broken leg for a fee has directly benefited the patient while generating income for himself.  Transactions do not take place unless each party to the transaction benefits.  Thus, the notion that someone must lose in order for someone else to “win” cannot survive the examination of any of the countless transactions that occur every day in a capitalist economy.

But the logical error regarding economic performance most relevant today is the myth that economic growth is overwhelmingly driven by … consumers.  It is the glaring misconception behind “stimulus” measures that endeavor to put “money in the hands of those who will spend it” and the same one that fuels the Keynesian and neo-Keynesian method of advocating government spending – such as extended unemployment insurance benefits and/or public projects – as a means of economic stimulus.  Such conclusions fly in the face of both logic and the empirical data indicating that such spending and “targeted” handouts have no stimulative effect whatsoever.

So where did this error come from?

Much of it stems from errors in assessing the size of the economy.  A common calculation used to determine economic strength is gross domestic product (GDP).  It is an attempt to assess the overall economic productivity of a country or nation-state over the course of a given time period – typically a year.  But it is impossible to correctly capture all of the disparate activities that take place in a dynamic economy in a single measure.  GDP is merely a flawed substitute for total economic strength even if it is the best measure we currently have available.

One of the major flaws with the GDP measure is that it includes government spending as a component comparable to that of private sector activities.  This tends to support the fallacy that economic growth can be stimulated or maintained by increased governmental expenditure.  But no allowance is then made for the difference in market driven spending to meet the needs of consumers which is overwhelmingly efficient and beneficial and spending by governmental mandate which rarely takes into account the needs of consumers and is, as a consequence, incredibly wasteful.  It is not spending, per se, that is economically advantageous, but rather investment in productive activities that creates wealth and prosperity in society.  As a matter of economic logic and historical evidence, the notion (most notably endorsed by Lord Keynes and pursued by the Roosevelt administration) that spending by the state generates wealth has been thoroughly discredited.

The second major flaw is methodological.  In an effort to avoid double-counting of wealth at various stages of production in the GDP calculation, intermediate goods and transitory capital goods are discounted in favor of final consumer goods.  While there is value in this methodology in determining a gross domestic product that does not count each stage of production and finished goods simultaneously, the shorthand method of avoiding a double count renders attempts to examine the components of the economy from a total GDP figure completely useless.  A commonly repeated fallacy is that consumer spending represents two-thirds of GDP, but that is only because the intermediate producer’s goods (which, arguably, are significantly more valuable) have been removed from the calculation.

Unfortunately, this belief in the primacy of the consumer in economic strength is behind efforts to “target” stimulus to those individuals most likely to spend whatever largesse the state dishes out.  No recourse to empirical data – such as the study of previous targeted expenditures – can dissuade the true believers from the defense of such methods because consumers are the most visible actors in the marketplace, so they must be the drivers.  But the fallacy of this position is the same.  One cannot spend oneself to prosperity either at the societal or the individual level.  In the absence of production, consumer action yields only scarcity and economic stagnation.

So who drives the economy?  Entrepreneurs.  Economists have understood this for decades but the general public reels.  How, it is asked, can a handful of big business types be of greater importance to the economy than all the “average Joes” buying goods and services?  The problem is that the function and definition of entrepreneurial action has been misunderstood.

Entrepreneurial action takes place whenever anyone in the marketplace, in anticipation of future demand, invests time, capital or resources in an attempt to meet those future needs.  It is not restricted to “big business” or even “business” at all in the sense of an incorporated entity.  The “average Joe” who undertakes action in the marketplace can be part of the entrepreneurial function.  Such action to meet future demands funnels capital to productive means increasing the demand for further inputs – more capital, other resources and labor.

This is the engine that creates jobs.  It is the entrepreneur who, in an effort to meet customer needs and improve his own situation, determines that those goals can be achieved by applying additional labor to his productive endeavors.  This is, in fact, the only activity that ultimately creates jobs.  Subsequently, this greater investment puts more resources in the hands of those “average Joes” in the form of “permanent” (in the relative sense) changes in their income stream and their supportable standard of living.  Attributing the driving force of the economy to the consumptive activities of the consumer simply fails to examine that which must happen first before the consumer activity can change.

Production – not consumption – yields economic growth.  It is the actions of the entrepreneur that drive the economy and it is only those policies that place more capital in the hands of those entrepreneurs – whether they be CEOs of Fortune 500 companies or small business owners or “average Joes” undertaking action to meet future consumer demand – that succeed in generating continued (or accelerated) economic growth.  Policies that ignore this dynamic – as politically popular as they may be – are doomed to inevitable failure.

Paul Krugman is exhibiting signs of schizophrenia.  A few years back, as the Bush tax cuts were being debated, he argued vehemently that such cuts were irresponsible in the face of a looming Social Security crisis.  More recently, however, he has adopted an Alfred E. Neuman expression and asked, “What crisis?”  On the other hand, John Konop, of Control Congress.org, has consistently argued that the system faces such a crisis that prolonged economic disaster waits just around the corner.  Who’s right?

Neither of them.  But it’s interesting to note what is right about their assessment of the situation, before going into what’s wrong.

Krugman is essentially conceding the very point that those predicting difficulties are making.  If the Social Security system is jeopardy because of tax cuts unrelated to the collection of payroll taxes, his position explicitly concedes that program can only be funded by additional revenues collected for the general fund.  While arguing – completely contrary to history – that retaining or returning to higher tax rates would make funds available for this later use, the concession that such funds would be needed to pay Social Security benefits highlights the inadequacy of the existing funding source.  Thus, the system as it now exists is in crisis (as elaborated last time) and Krugman’s current stance is completely disingenuous. 

John Konop’s point, on the other hand, is based on a basic accounting assessment of that funding source.  He simply forgets that the whole reason that the Ponzi scheme has lasted for seven decades is because the government is not constrained by basic accounting or contract rules.

According to the trustees of the program, the un-funded liability of the Social Security system is currently $15.6 trillion dollars – an amount larger than our current GDP.  The un-funded liability for Medicare is currently $76.5 trillion, five times larger even than that – in no small part due to the prescription drug benefit foolishly added by the current administration - but, while many of the same points made here (and in the last column) are relevant to Medicare as well, my focus, at present, is on the system that, among other things, helped prolong the Great Depression.

For all the money paid in and all that additional debt incurred, this program, amazingly viewed by many as one of the most successful programs ever devised by government, those paying into the program get a truly dreadful return – far below any market rate investment, even essentially risk-free instruments, and for a huge number of participants, particularly minorities, the return is negative.  Wow!  What a deal!

But I have argued that, while the system is clearly in crisis, and simply cannot survive in its current form, it is not the looming economic catastrophe that some have predicted.  How can I make such a prediction given the sheer size of the numbers involved?  It comes down to two things: a) the constraints, or, more specifically, their lack, on government and b) the responses of actors in the marketplace to current economic conditions.

Social Security was originally sold as an insurance program, not a retirement program or a social responsibility - in fact, Roosevelt himself argued against it being any such thing - though that, in and of itself, is debatable, since an insurance program would involve policyholders (in this case workers) paying the cost of some defined benefit to be provided under a given set of circumstances. If you want, you can go to an insurance company today and purchase an open ended annuity to begin at age 67 (or any other age, for that matter) and you can do so for less than the current system costs you.  Moreover, you can transfer that asset to someone else if you so choose. You could even cash it in at an earlier date in an emergency if you needed to based upon the value of the assets invested up to that time.  The notion that the current system is either a real insurance program or unduly risky if privatized in some manner is utter nonsense.

A quote I considered for my previous column highlights the point.  When asked whether there was a Social Security Trust Fund, CNN expert Dr. Allen W. Smith, PhD, noted, “Every dollar of the Social Security surplus has been borrowed by the government and spent for other government programs. The only thing in the Social Security Trust Fund is government IOUs called ‘special issues of the Treasury’.  These ‘special-issue’ securities have no commercial value because they cannot be sold in the market place. In essence, these IOUs represent a promise by the government that, in order to pay Social Security benefits, it will obtain resources in the future equal to the value of the securities.”

I have only one objection to Dr. Smith’s comments: no such promise exists.

Like the issue of whether or not the police are obligated to protect you, the courts have determined that the United States government is not obligated to honor any previously made promise to provide you with Social Security or anything else.  The history o