In a Republican ad during Ronald Reagan’s 1980 run for president, a Tip O’Neill lookalike was driving along while oblivious to the fact that his car was running out of gas. The Republicans’ intended meaning was that the Democrats were not paying attention to the mess the country was in, a mess that they helped create. But what I took out of it was more literal: the idea that the Democrats’ energy policy, one of the worst parts of Jimmy Carter’s four years, was a disaster that the Democrats refused to admit. (Previous presidents Richard Nixon and Gerald Ford had actually started the bad policies, but that’s another story.)
I have the same reaction now as I look at energy policy in Europe. Except that this time, one of the advocates of a destructive energy policy, Britain’s Liz Truss, is claiming the mantle of free market advocate and former prime minister Margaret Thatcher. In setting out her policy, she ignores some very basic economics. And the European Union is making similar mistakes.
Prices’ Crucial Role
“A price is a signal wrapped up in an incentive.” So says George Mason University economist Alex Tabarrok. His point is that prices aren’t just arbitrary numbers: they actually signal real events happening in an economy. So, for example, if the price of oil rises, that means either that the supply of oil has fallen or that the demand for oil has risen, or both. That’s the “signal” part.
The “incentive” part is twofold.
First, the increased price causes users to ask themselves questions such as “Is this use of oil or gasoline worth at least the price that I now have to pay?” They will sometimes answer “no.” If that’s what they answer, they’ll cut that use.
Here’s how I put the point about oil users’ responses to higher oil prices in an August 1990 op-ed in the Wall Street Journal shortly after Iraqi ruler Saddam Hussein had invaded Kuwait:
They take fewer trips to the stores and fewer driving vacations, but don’t stop driving to work. Utilities switch from oil to natural gas. People insulate their houses and close off unused room. In a thousand different ways, oil users make subtle adjustments that—voila—cause the amount they consume to equal exactly the amount supplied.
The second important incentive on the supply side is that producers of oil have an incentive to produce more. If they expect the higher price of oil to persist in the long run—and the futures market prices will give evidence to either back or gainsay that expectation—then they will invest more in exploration for more oil. (This assumes, of course, that various governments let them do so. The current federal administration, under Joe Biden, has been particularly hostile to oil exploration.)
But even in the short run, oil producers have ways to produce more. They can uncap wells that were not worth producing from at, say, $50 a barrel but are worth producing from at $100 per barrel. They can engage in what’s called secondary or tertiary recovery of oil. Secondary recovery involves injecting water or gas to extract more oil. Tertiary recovery, also known as enhanced oil recovery (ERO), is the next step. See this Department of Energy link for a further explanation of ERO. Each method squeezes more oil, sometimes a lot more, out of existing wells. They can do more fracking. With all these ways, more oil will be supplied at the higher price than at the previous lower price.
Bingeing on Energy
With this basic economics in mind, let’s consider British Prime Minister Liz Truss’s energy policy.
Starting in October, Britain’s government will cap prices to consumers so that the average household will pay no more than $2,875 per year for energy. The government will make up the difference with subsidies. This cap on prices will give households an incentive to use more energy.
The program will last two years for households and a similar program for businesses will last six months. The difference that the government will make up is expected to be huge. According to an article in the Wall Street Journal shortly after Truss’s announcement, “economists say [the program] is likely to be worth more than $120 billion.” Of course, that’s a non-economist reporter speaking. The program may cost more than $120 billion. But, because it will cause people to use energy in uses that they value less than the cost, the program will be worth substantially less than $120 billion. Economists rarely confuse worth (value) and cost. That many billions is a large number for an economy much smaller than ours. Britain’s GDP is about $3 trillion a year. So the expenditure over two years is a hefty 2 percent of GDP.
In introducing her policy, Truss said, “Extraordinary challenges call for extraordinary measures.” Actually, they don’t, unless by “extraordinary measures” she means letting the market work, which she clearly doesn’t. Her line, though it sounds good, reminds me of a segment from a British comedy series, Yes, Prime Minister, which is based on a fictional British prime minister. In that segment, Sir Humphrey, a longtime bureaucrat, says, “Something must be done. This is something. Therefore, we must do it.”
I should not leave this topic without mentioning one pro-supply policy that Truss proposes: allowing fracking in Britain.
In the EU, Price Controls and Heavy Taxes on Producers
Policy makers in the European Union are proposing a different mix of policies: price controls on energy combined with heavy taxes on energy producers with the revenue from those taxes going to subsidize consumers. What’s not clear from the news accounts I read is whether there really will be price controls or whether the revenues from the taxes will simply be used to subsidize consumers. If price controls are imposed, then Europeans will experience the standard problems with price controls: shortages and formal or informal rationing. For more on this, see my earlier Defining Ideas article titled “Price Controls: Still a Bad Idea.”
But if price controls are not imposed and the revenues from the taxes on producers are used to subsidize consumers, then energy users will have an incentive to overuse energy. This seems to be the direction that the German government is taking. According to a September 8 story in the Washington Post, German Chancellor Olaf Scholz will impose high taxes on oil producers and use the revenues “to reduce consumer prices for gas, oil, and coal.”
One big difference between the Truss policy and the various EU policies is that Truss is not proposing heavy new taxes on energy producers. She seems to understand that the reason we got where we are is that there has been a reduction in the supply of energy to Europe, due in part to the various “green” energy policies in Europe and in part to both Vladimir Putin’s reduction in supply and the EU’s forced reduction in imports from Russia. So, when supply is less, it’s not a good idea to tax producers. That causes them to produce less than otherwise, not more.
In making her proposal to tax producers more heavily, European Commission President Ursula von der Leyen stated, “In these times it is wrong to receive extraordinary record profits benefiting from war and on the back of consumers.” She added, “Profits must be shared and channeled to those who need it the most.” Karl Marx could not be reached for a comment.
Two Better Ways to Handle High Energy Prices
There are two better ways to deal with high energy prices.
The first is my go-to way whenever governments have been big contributors to the problem. I call it “Don’t just stand there; undo something.” In this case, get rid of the “green” energy policies that have helped cause the problem and also get rid of restrictions on using energy from Russia.
Many policy makers will balk at that, especially the part about Russia. Which brings me to a standard economist’s solution. Don’t try to redistribute wealth by setting prices. Instead, give people money directly so they can choose how to spend it. And don’t, as in the EU, levy extra-high taxes on the very people who are trying to solve the problem, namely, energy producers. That way, you don’t distort markets and destroy wealth. You still destroy some wealth, of course, because all taxes cause deadweight loss—losses to some that are gains to nobody. But the losses per government dollar spent are certain to be less than the losses per dollar spent with either the British or the EU approach. Also, because the direct subsidy policy would be more efficient, the government wouldn’t need to spend as much.
Ignorance, or Lust for Power?
A little economics goes a long way. But first you must understand the economics. I’ve criticized the thinking of the various politicians and bureaucrats in Europe who want more interference in free energy markets. It’s possible, though, that many of them do understand economics but also understand that the more they intervene, the more power they have over people’s lives. I remain agnostic about whether ignorance or power lust is behind the European proposals for more intervention. I would hope it’s ignorance, because then people can be educated. But I’m not confident that it is.