Saturday, September 5, 2009

Contra DeFazio on Oil

By Michael Labeit

Rep. Peter DeFazio has proposed a new tax scheme to be levied upon institutional speculators claiming, among other falsities, that it will substantially hedge against high oil prices. DeFazio has indicted speculation in the past for allegedly helping to cause the 2008 oil bubble and he believes that it again is behind the current oil price rise.

The Hill newspaper has quoted DeFazio stating that “The tax is simple; it imposes a small burden that penalizes short-term traders for speculating on the price of oil” and that “This legislation exempts legitimate hedgers from the transaction tax. Since the tax is on speculation only, it deters speculation and undermines much of the crude oil price bubble.” According to The Hill newspaper DeFazio’s plan involves “a 0.2 percent transaction tax on crude oil futures contracts” and would “tax the options for oil futures (in other words, the premium paid to have the option to buy a futures contract) at 0.5 percent.”

As always, beware of politicians bearing gifts.

DeFazio exhibits a basic misunderstanding of economics and of economic history typical of most politicians. The rapid rise of oil prices that plagued the global economy in 2008 to which DeFazio has referred to before had two chief causes: the Fed's inflationary monetary policy and the federal government's various supply constraints, the former being the primary cause between the two.. Supply restrictions courtesy of Uncle Sam have been well-documented. Congressional regulations have obstructed U.S. oil exploration and drilling in numerous places, most notably ANWR, the Outer Continental Shelf including areas off the coast of Florida where Sino-Cuban oil ventures currently operate, the Mid-west oil shale region, and others.

But it is the Fed that must be given the distinction of being the principal inflator of oil prices, since it is the principal inflator of prices per se. Under the tutelage of Alan Greenspan the Fed executed a policy of synthetically low interest rates, rapidly expanding the money supply partly in response to the 00'-01' recession. By engaging in monetary inflation and artificially lowering interest rates, i.e., decreasing rates further than what a free market would have inevitably established, the Fed sent false signals to entrepreneurs, giving them the impression that the market had decreased interest rates or the price of loanable funds, that market time-preferences fell or, in other words, that the future-orientedness of consumers had increased when in fact it had not.

With the Fed's monetary inflation underway, business undertakings that once seemed unprofitable now seemed profitable after all given that now loanable funds were less expensive to acquire. With this decrease in the price of bank credit came an increase in the quantity of bank credit demanded – entrepreneurs used this new opportunity to purchase loanable funds and use those funds to bid for and purchase productive factors (real estate, labour, and capital goods) with which to embark on those now "profitable" undertakings. The productive structure of the economy lengthened and widened as more inexpensive bank credit fueled a greater entrepreneurial demand for capital goods. This greater entrepreneurial demand for capital goods raised capital good prices and financed the growth of the capital goods industry. "Higher-order" entrepreneurs entered the market to satisfy the growing entrepreneurial demand for capital goods.

Oil was and is a very "non-specific" or versatile capital good as it is used to produce an array of other capital goods and consumer goods. Its versatility naturally makes it more marketable and this characteristic of oil promptly expressed itself as oil prices flew from around $16.21/barrel in December 2001 to a record $147..17/barrel on July 17th 2008. Thus, as interest rates on bank credit fell due to Fed monetary inflation, entrepreneurs acquired more bank credit and increased their demand for, among other things, oil, driving the price to new levels far beyond current production capacity which was and still is reeling from its own problems caused by government coercive intervention.

Let's contrast this brief but essential history of the movement of oil with the movement of the fed funds rate which is a primary monetary instrument of the Federal Reserve. The fed funds rate peaked at 6.50% on May 16, 2000. The Fed initiated its descent on January 3rd, 2001 by reducing it to 6.00% and steadily decreased the fed funds rate ultimately to a low of 1.00% on June 25th, 2003 In response to price inflation fears the Fed began increasing the rate after June but the expansion of the money supply had already occurrred thus ensuring rising capital goods prices. The Fed's monetary inflation coincides well with the oil price rise
-Bolton, Alexander. "AFL-CIO, Dems push new Wall Street tax." The Hill. August 30th, 2009. -"History Of Illinois Basin Posted Crude Oil Prices." Illinois Oil & Gas Association. -"History of the Target Fed Funds Rate from 1990 to The Present." The Federal Funds Rate (Fed Funds Rate).

Michael Labeit is an economics major, a disgruntled army reservist, an aspiring freelance writer, and an amateur logician. He currently resides in the People's Republic of New York City and can be reached at

Copyright 2009 EPJ Group LLC


  1. Thanks for the opportunity.

    I'd like to thank the Academy, my lawyer, my chauffeur....

  2. Any successful effort to curtail speculation in oil futures, by whatever source, should be applauded.
    The price of gas, diesel and other petroleum derived products has wide impact on the economy of the the world. Let the monied interests go to Las Vegas if the need to gamble gets too overwhelming. . .

  3. I get the awful impression that someone has not read my argument. Do you not believe that the Fed has got any role? If favorable conditions allow, I will respond at length and with haste my dear statist.