February 20, 2012

The Oil Market Panic

Politicians on both sides of the aisle must embrace the principle of laissez-faire.

The high price of oil is once again a front page story in The New York Times. Part one of its story asks why the prices are high now. Part two of that story asks what, if anything, should be done in response to those price increases. The short answer to the first question is that the increase in prices is due to contractions in the supply of oil driven by the instability in the Middle East. The short answer to the second question is that we should do nothing at all.

The greatest casualty of the current debate over the price of oil is to turn sensible market responses to its scarcity into grist for a political mill in an election year. The blame game between the political parties is likely to lead to flawed reform proposals that offer no short-term relief, but do impair the long-term efficiency of oil markets.

 Illustration by Barbara Kelley

Without question, the problem can be traced back to a renegade Iran. For good and sufficient political reasons, the West has come to see that the Iranian nuclear threat is not just bluster. Indeed, it poses far greater risks to world peace and the political order than even a major disruption in oil supplies.

Hence an anxious West has now put into place a reasonably effective concerted effort to cut off Iran from the world’s banking system, and to block the use of Iranian oil internationally, which has been made easier by the Saudis’ willingness to expand their own shipments into the world markets. Nor have the Iranians sat back idly. They have cut off exports to the United Kingdom and France, a move that is largely symbolic. But the Iranian threat to close the Strait of Hormuz, through which about one-third the world’s oil supplies travel, is not symbolic. Nor is the movement of the U.S. aircraft carrier, the U.S.S. Abraham Lincoln, into the Strait of Hormuz, merely symbolic.

For both the short and the middle term, these developments have driven the base-line price of Brent crude from the North Sea up to around $119 per barrel. That translates into a potential price at the pump of about $4.25 per gallon, which undoubtedly will eat into the pocketbooks of many Americans. The blogosphere is thus filled with accounts of how ordinary Americans are being forced to tighten their belts as a result of the high price of oil. W. Howard Coudle, an ordinary American recently quoted by the Associated Press, says that the rise of his monthly gasoline bill from $60 to $80 in the last eight weeks has made a difference: “We're going to have to drive less, consolidate all our errands into one trip. It's just oppressive."

What, if anything, should be done in response to the rising price of oil?

His are genuine hardships, as are those of millions of other Americans. Coudle’s heartfelt claim of “oppression” is an early harbinger of political discontent. But the private adaptive responses of Mr. Coudle make far more sense than any political response to the rising price of oil. The question on the table is how best to respond to the disruptions in oil supplies, not to pretend that these disruptions do not exist. On this score, the great advantage of a market system is that it forces Mr. Coudle (and everyone else) to think hard about the relative value of the goods and services he consumes and to make cutbacks in a cheap and rational fashion. In both good times and bad, people are always having to decide which goods and services to spend their incomes on, and which to forego.

Price movements give them an accurate, instantaneous, and impersonal picture of how other people value various goods and services. When oil prices rise, its least valuable uses are the first to drop out of the system. The decisions are typically made on a continuous basis, so that if some people find that they have cut back purchases by too much (or too little), they can increase (or decrease) their purchases in the next pricing period. Spurred on by these price increases, people can also make changes in their spending patterns elsewhere to offset the inconvenience of the higher prices for oil products. Purchasing a hybrid, insulating your home, and moving closer to work are just some of the many ways to save money. Good luck to Mr. Coudle, who provides an object lesson in how that task should be done.

The great risk is that the government will undermine the market by resorting to centralized devices to cap the price increases or to dictate its collective vision of the just price. Now is the time to recall the lessons of Friedrich Hayek’s best writing, the scholarly essay “The Use of Knowledge in Society” (1945), which is about the superiority of a decentralized price mechanism in response to system-wide shocks. As he reminds us, “The knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all separate individuals possess.”

Now is the time to recall the wisdom of Friedrich Hayek.

Mr. Coudle is one such bit: he knows far more about his peculiar situation than any analyst or regulator. The imposition of any system of government subsidies or controls will disrupt the market’s vital process of continuous adaptation; it will also cost a fortune to put into place. The “hands off” motto of laissez-faire capitalism has never been more pertinent than in this oil crisis.

This reasoning has been lost on our leading political figures, on both sides of the aisle, who have sophomorically responded to the current oil run-up. The point here is not that every proposal made on this question is wrong. Rather, it is that the reforms have nothing to do with the short-term shifts in oil supplies. Once that extraneous element is removed from the discussion, it looks as though neither side in the current political environment has anything sensible to say about the current crisis.

Start with the Republicans, who are now salivating at the prospect of using the rising price of oil against President Obama. But just what does House Speaker John Boehner hope to accomplish when he tells his fellow Republicans to seize on the gas-pump anger, bemoaning the $4.00-plus prices at the pump? He can’t responsibly say that he wants these prices to be lower if they rose in response to scarcity. Nor can he lay the blame for the current dislocation at the foot of Obama, whatever else the president may have to answer for.

The only way in which to lower oil prices is to subsidize its consumption in some form, which is where Boehner’s thinking necessarily leads. Those subsidies have to come from somewhere, which means new or higher taxes. Another problem with subsidies is that they lead to the relative overproduction of the subsidized product and the relative underproduction of its close rivals. The president himself has called for greater subsidies for solar energy, whose entrepreneurs should be left to sink or swim on their own. Boehner is making the same mistake for oil. He needs to not panic in response to bad news.

Senator Rick Santorum must also tone down his rhetoric when he bashes the Democrats: “They want higher energy prices. They want to push their radical agenda on the public. We need a president who is on the side of affordable energy.” Not so. In this environment, higher prices are the best response to contracting supplies. There is, therefore, nothing radical in President Obama’s decision to stay on the sidelines on this matter. But there is a great deal of freighted meaning when Santorum mentions “affordable energy,” for it calls to mind a policy of state subsidies that distort relative prices across the board.

Oil subsidies would have to come from somewhere, which means new or higher taxes.

Newt Gingrich’s solution is no better. He wants to keep gasoline prices at $2.50 per gallon, by national petition no less. Gingrich is right, I think, to urge for an increase in domestic drilling and the opening of the Keystone XL pipeline. There is indeed every reason to think that the president made the worst of all possible decisions in killing a pipeline that could have cemented America’s relationship with Canada, rationalized production and distribution of oil in the United States, and reduced the risk of pollution by blunting spillage risk from tankers steaming toward China loaded with oil.

That's all well and good. But recall that there is no evidence whatsoever that suggests that opening the pipeline or increasing domestic oil production, both desirable, will lead to some mythical $2.50 per gallon price at the pump any time soon. Once the right institutional arrangements are made on both of these points, supply should increase, and, on average, prices should decline as consumption increases. But we must never tie government policy to particular price levels. Politicians must set the right institutional arrangements and then let the cost of production and relative demand set prices.

The political ignorance on the Republican side of the aisle is, alas, fully reciprocated by the unwise pronouncements that come from the Democratic side. The president’s own personal statements exude sympathy for those whose lives are made more difficult by higher gas prices. But by themselves, those words don’t translate into constructive policy. Nor does it help that Alan B. Krueger, who chairs the president’s Council of Economic Advisers, takes the occasion to note that the reduction in the payroll tax helps to soften the blow from these prices.

Again, this political maneuvering is just not helpful. The payroll tax reduction is one way to pour money into the economy, and it is surely better than some top-down stimulus program that spends the money on pork. But the difficulty with that payroll tax reduction remains: the long-term return to economic health is not facilitated by short-term fixes that add uncertainty into the system without addressing the serious structural defects of the current tax code, which contains too much progressivity and too much complexity.

If Krueger’s remarks don’t help very much, comments from Democratic firebrands only make matters worse. “House Republicans are very good at using every argument they can to shield oil companies from paying their fair share. They have been relentless and fearless protectors of oil company profits.” So says Congressman Steve Israel (D–NY), who uses the term “fair share” as shorthand for every tax the oil companies pay should be increased. His mindless populism assumes that oil company profits are in and of themselves a bad thing. But, everything else being equal, rising profits generate more jobs, more dividends, and, yes, more tax revenues than can be wrung out of a stagnant industry. The oil industry is so complicated that it is easy to postulate it could benefit from some unwise subsidy. But by the same token, any special regulatory burdens or taxes on oil companies should be removed in order to achieve the central goal of a tax system, which is to preserve the same investment priorities across sectors and firms that would exist in the hypothetical non-tax world.

The overall lesson here should not be forgotten. The desire to meddle politically in economic matters will only get worse when politicians on both sides of the aisle start from this erroneous, but shared, premise: simple changes in prices count as evidence of a market failure that justifies government intervention. They don’t. Price increases should not lead to a call for price limits. The real problem is the trouble brewing in Iran and the Strait of Hormuz. Politicians should neither panic nor pander, especially when their political energies are needed to reach a diplomatic or military solution for a serious international breakdown that requires our urgent and unified national attention.

Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).

Letters to the editor

Obama Needs to Get Off the Sidelines

Epstein says there is freighted meaning by Santorum remarks, but could we also say that a president that is on the side of affordable energy would be one who allows the Keystone pipeline, who encourages drilling in the Gulf, and who promotes fracking in the Mid-West? Maybe I am being too naive but I think Epstein may be too pessimistic.

---Rich Egan

Epstein Gets It Half Right

Mr. Epstein only got it half right—there is a future, which he discusses and then there is a past, which he ignores. This is borne out by the following quote from the article, "The overall lesson here should not be forgotten. The desire to meddle politically in economic matters will only get worse when politicians on both sides of the aisle start from this erroneous, but shared, premise: simple changes in prices count as evidence of a market failure that justifies government intervention. They don’t."

He only applies this lesson to current policy choices and ignores the vast number of previous and erroneous policy choices. And I would suggest his assessment of the responses he attributes to the Republicans (which I believe Mr. Epstein misstates for the purpose of his article) also ignores the past. Worse, they are placed on par with Democratic responses—which based on the prescriptive measures is a false equivalence. As Mr. Epstein well knows, government intervention by “price fixing” (no matter what mechanism is used—price controls, taxes, environmental regulations, etc.) invariably fails. My sense is that most of the Republican responses that are not outright “price controls” (and no one is advocating that) also include the lifting of the burdensome “hand of government” that exists today due to past and un”justified government intervention” on the oil and energy industry.

Fixing the problem requires both an understanding of what the outcome is of specific policy choices—and an understanding of the historical “bad choices” so that they can be undone and supplies increased. It is far less a problem when the price of oil fluctuates 10-20% around a $40 per barrel price than around a $120 price.

----Robert F. Stockwell

Letters to the editor may be sent to definingideas@stanford.edu. Editors reserve the right to reject or publish (and edit) letters.