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Airlines Lobby for Tighter Control on Oil Speculators

8/5/2008 --

But efforts to regulate markets are misguided, says Ross professor.

Ann Arbor – Major U.S. airlines recently emailed letters to frequent flier customers asking them to, in effect, lobby Congress for tighter controls on oil market speculation. The airlines, struggling to cope with skyrocketing fuel prices, argue that "unchecked market speculation and manipulation" are a major cause of those high prices. E. Han Kim, Fred M. Taylor Professor of Business Administration and director of the Mitsui Center at Ross, understands where the airlines are coming from, but doesn't agree that regulation of the markets is the answer. In fact, market speculation has some benefits, Professor Kim says.

The airlines look like they're asking customers to lobby Congress on their behalf. Why are they doing this?
Kim: They are desperate and this is a desperate measure, crying for political help. They are doing this because they have run out of other means to deal with skyrocketing oil prices. When companies are in financial trouble, they usually cut fat by various means of restructuring. Unfortunately for airlines, there is just no fat left. During the past few years, they have cut their fat by restructuring, cutting wages and the workforce, by going bankrupt, and by merging or forming alliances. Now the airlines are at their bare bones.

Is it risky at all for them to ask for the public's help and do you think it will work, that it will help popular opinion on this issue?
Kim: It's actually not new, mobilizing public opinion. That's a tool large failing corporations sometimes use to get governmental help. Steel makers used it to get tariffs against foreign imports, and auto makers tried it to get protection against imports. What do they have to lose for asking? Not much. If I may speculate a bit, this could be the first step toward asking the government for help and/or a big industry-wide increase in airfares and fees to pass the high oil price onto consumers. It could very well be that they're softening up the public.

Does their argument have merit --- that speculation is driving up oil prices?
Kim: Yes and no. As an economist I would say there's no merit at all. But having experienced a similar situation last year while serving as the chair of the board of directors of Posco, one of the largest steel companies in the world, I’m somewhat sympathetic. To make stainless steel you need nickel. That's the key ingredient. And nickel came under a similar speculative attack. High speculation may increase short-term volatility, although there is no rational explanation for it, unless some speculators engage in hoarding or illegal manipulation. Many executives’ instincts were to blame the speculators, not necessarily because they were convinced speculators were at fault, but more because they are convenient scapegoats. We knew that it was not the speculators who were increasing nickel price; rather, the culprit was the dramatic increase in demand during the past few years. Speculators don't change the long-term trend in price.

Businesses have to plan, and plan for the long-term. Short-term volatility makes it difficult for strategic planning, and volatility is painful to deal with. This short-term volatility may impose a cost on running companies, and that's where the airlines are coming from.

But as an economist, it doesn’t really make much sense. Speculators play a useful role---they make the market more liquid, helping the price better reflect the long-term trend of supply and demand. This helps support long-term stability in the economy by forcing businesses and consumers to make the necessary adjustments for sustainable growth in the economy.

The airlines say in the letter that the price of a barrel of oil goes up with each trade and consumers pick up the final tab.
Kim: That oversimplifies things. The long-term trend in price is not affected by speculation. However, if the short-term volatility interferes with airlines’ long-term planning and creates friction in running their business, the costs do get passed onto consumers. If this volatility is all they were concerned about, they could have done something about it by hedging. And that's what Southwest did, which is doing much better than other airlines.

What about the regulatory limits on market speculation the airlines are calling for? Kim: The kind of regulation they want implemented is harmful to the economy. A good example is the price controls of the Nixon administration in the early 1970s. They thought inflation was getting out of hand and imposed price controls. Now we can see that price controls only put a lid on the short-term price pressure without addressing the cause. When the controls were lifted, the pent-up pressure for price increase led to an immediate and sharp increase in prices. I know the airlines are not asking for price controls, but the point is that any regulations creating friction in the pricing mechanism in the market are hurtful for the long-run, sustainable growth of the economy.

Speculators, whether you like them or not---actually, it is pretty hard to like them---are important players for the proper functioning of the market. They are important because they provide liquidity, which is necessary for the market to do its job. Well-functioning markets are vitally important for the good of the economy and for the welfare of consumers in the long run. And the regulatory limits on market speculation reduce the useful role provided by the market. They would simply replace short-term volatility with a long-term volatility. Long-term volatility could be more dangerous and painful, because it takes away the interim time for people to make gradual adaptations to a new environment. Making relatively small behavioral changes over time tends to be less disruptive and less painful than having to make a big change all at once.

The inevitability in all of this is that air fares have to go up. Higher oil prices mean two things, higher air fares, and that will mean less air travel. Perhaps people will rely more on distance communication through teleconferencing and internet.

And maybe that's necessary. The world is running out of resources. We are over-consuming. That's what the market is telling us, that we are consuming too much. And price is the best tool to force us to consume responsibly which, by the way, may help us deal with environmental issues and the greenhouse effect.

Written by Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu