The American Energy Crisis

It’s a sad sight. Chrysler and General Motors in general crisis, and Ford not far behind. Predictions of 10M cars or so going of American roads as a consequence of the high oil prices and American politicians blaming speculators for these (something we would expect in France, not in the center of capitalism). How did it come to this? 

Well, it turns out policy matters after all. Instead of taxing it’s use, energy is one of the most subsidized sectors of the economy. Is there a reason for it? Perhaps, but it’s a political one, certainly not a rational one in the sense that it furthers the functioning of the American economy.

We are pretty liberal when it comes to markets, let them function, and more often then not, they lead to socially desirable outcomes.

However, two asides are warranted:

  • One should not close one’s eyes for the shortcomings of markets (like external effects, high transaction cost, and information asymmetries. The latter describes a situation in which one party can exploit information the other party doesn’t have)
  • One should, in such cases, try to correct the market mechanism first, rather than bureaucratic intervention, but if the latter is warranted, one should not hesitate. We are generally in favour of market conformed intervention (an excellent example is tradable pollution rights).

Energy involves rather large external effects. Basically, the prices in energy markets do not reflect all socially relevant cost to society, like pollution and climate change. Prices need to be higher to reflect these costs, and as a result, consumption will be lower.

Now, instead of subsidizing energy, it should be taxed. There is nothing wrong with that, not even in principle. Pollution and climate change are the effects of failing markets. It might be akin to a classical marxist position, but we believe that market failures need to be addressed to save the market mechanism in general.

So at the least, some of these external effects need to be internalized, that is a fancy economist way to say that prices need to reflect all social relevant cost, including those of pollution and climate change. In Europe, gasoline is heavily taxed. Americans may think they get a rough deal with $4 a gallon, but in some European countries, prices are above $10 a gallon.

Still, these countries function, they have not come to a grinding halt, and they are a lot more energy efficient. Another advantage is that with taxes so high, Europeans have noticed much less of the rise in oil prices, as the tax part of retail prices remains fixed.

Energy is also scarce, and one reason it’s price is now rising so inexorably (although we predict that we are at a relative top in oil, prices will come down before the year is out). As others claiming their stake, consumption patterns in the US were based on artificially low energy prices (subsidized instead of taxed).

Another way would be to raise energy standards on cars. In most other advanced economies, these standards are a lot higher compared to the US (double in the EU, even more so in Japan) . Detroit (and representatives from both Democratic and Republican parties) has fought successfully against raising them.

The reasoning behind that was faulty (and it still is, but at least it’s disastrous effects are now clear for everybody to see). Higher fuel standards would supposedly give foreign car manufacturers an unfair advantage because it was better at producing smaller, more fuel efficient cars. Yeah, right.

A couple of observations:

1) It is quite likely that the foreign competitive advantage in more fuel efficient cars was largely the result of the higher fuel efficiency regulations elsewhere. Unlike what lobbyist for special interest groups argue, it is often better to impose high standards, as this hones domestic business in fulfilling them and give them an advantage when the rest of the world moves

2) Now that energy prices are moving up (at least party because energy efficiency in the US is so low), the competitive disadvantage of US car manufacturing is fully exposed. But it might be too late now. Demand for SUV’s more than halved from last year, according to Ford.

3) Had the US instigated on two policies most other advanced nations embarked upon after the first energy crisis (1974), namely higher fuel standards and fuel taxes, no doubt energy efficiency would have risen more or less on a par with Europe and Japan. In fact, the 1990s witnessed a move backwards when SUV’s became wildly popular.

Since the US, with 4% of the world population still consumes a quarter of world oil, This matters tremendously. While rising demand from China gets all the blame (after speculators), it’s probably fairer to say that SUV’s have been at least as important, if not more so in terms of rising oil demand.

Since small imbalances between demand and supply can produce wild price movements, this matters a lot more than one might think at first hand. It’s far from unlikely to assume that the effect of SUV’s is something in the order of 2-3M barrels a day. With 3M barrels a day less demand we would certainly not be at $140 per barrel of oil, we might not even have made $100..

Like we argued above, we’re all for free markets, as long as all socially relevant cost are reflected in the price. And when they’re not, it’s amazing what can happen. But now the adjustment process will get a lot more bloody.