[Viewpoint] Economic security is a mirage

Even as the world becomes more integrated, the word “security” crops up again and again, as in “food security” or “energy security.” Typically, this means a country creating and controlling production facilities no matter what the cost.

Thus, Arab countries grow water-hungry grain in the desert, and China acquires part ownership of oil companies in Sudan. Are these economically sensible actions? If not, what should the world do to reduce the need for them? Let’s start with ownership of foreign resources. One might think that a country that owns foreign oil can use the profits from its sale to insulate the country’s economy from high world oil prices. But this makes no economic sense.

The world market prices oil according to its opportunity cost. Rather than subsidizing the price in the domestic oil market (and thus giving domestic manufacturers and consumers an incentive to use more oil), it would make far more sense to let the domestic price rise to the international price and distribute the windfall profits from foreign oil assets to the population.

The key point is that fundamental economic decisions should not be affected by the ownership of additional foreign oil assets. But, because of political pressure exerted by small, powerful interest groups, windfall profits will inevitably be spent at home on unwise subsidies. As a result, the acquiring country will, if anything, make suboptimal economic decisions.

Could the purchase of foreign resources lead to more stable levels of national income? A purchase will always look beneficial if one looks backward after the resource price has risen.

But if the price of oil falls, citizens suffer a loss of income and wealth (relative to having invested the money elsewhere). Assuming the foreign oil assets are priced fairly at the time of purchase, the country benefits only when the purchase helps smooth its income; however, purchases may increase income volatility even for a country that relies heavily on oil.

For example, in large countries like the United States or China, which account for a significant portion of world demand, the world price of oil is likely to be high when the country is growing strongly and citizens have lots of income, whereas the price is likely to be low when the country is doing poorly. Foreign oil assets are a bad hedge in such cases, for they subtract from citizens’ income when it is already low and add to it when it is high. Even if owning oil assets is a useful hedge (in the case of a small, oil-consuming country), it is not clear that buying stakes in opaque companies in foreign countries is the best strategy. A country’s property rights in foreign oil assets are likely to diminish as the oil price rises.

Even if the foreign company does not start squeezing out its minority owners, its government will be tempted to expropriate foreign owners’ profits through windfall taxes (if the government is sophisticated) or nationalization (if it is unsophisticated) - especially if its voters feel, with the benefit of hindsight and populist incitement, that the assets were sold too cheaply.

But perhaps what countries really fear is not so much high prices but a total market breakdown and descent into an autarkic “Mad Max” world in which oil is scarce, no country is willing to allow trade the oil it does produce, and there is no world market clearing price.

If such a situation were to occur, ownership of oil assets abroad would most likely become worthless, as each country would only get to use oil produced within its political borders (or within nearby borders that could be invaded).

It is in this kind of world that seemingly nonsensical behavior like growing grain in the desert to ensure food security begins to make sense. Alternatives do need to be explored, including more efficient use, diversification into more easily accessible substitutes and reduction of overall consumption (though in all these cases, it is easier to deal with energy shortages than food shortages). Moreover, even in such a bleak world, it is difficult to imagine the international market breaking down completely or for very long. Indeed, one can easily imagine black marketeers and smugglers buying grain where it is available and transporting it for sale in countries where it is not.

Unless governments build leak-proof barriers around their countries - and the costs of that would likely be prohibitive - an implicit world market would be re-established.

Nevertheless, many countries understandably make decisions to locate production internally and in order to protect it against foreign trade, fearing market breakdown through war, trade sanctions or simply shortsighted decisions by foreign governments to protect their own populations from price increases.

Paradoxically, once a country ensures its own security, it has weaker incentives to avoid the market breakdown that prompts the initial search for security.

International agreement to ensure that countries do not prohibit exports, especially of critical commodities, except under severely (and verifiably) adverse domestic circumstances, would help reduce fear of market breakdown. Similarly, the creation of international strategic resource reserves on neutral territory, and under neutral management, could help reduce concerns of politically motivated disruptions.

Unfortunately, all of this requires substantial international political consensus, cooperation and goodwill - all of which are in short supply today. Until we find the collective will, the drive for national economic security will continue to lead to collective insecurity.

*The writer is Professor of Finance at the University of Chicago’s Booth School of Business.Copyright: Project Syndicate, 2010.

By Raghuram G. Rajan