Gasoline: Too High and Too Low

We often hear that the internet has created a brave new world of globalization. But the truth is that the internet had very little to do with it. The net has allowed certain jobs to be outsourced, like help lines moved from your home town to India, where nobody can give you any help. But globalization preceded the internet, and depends on two other things. Namely, the shipping container and cheap oil. Prior to the shipping container, goods had to be manhandled onto a truck at the factory, manhandled off the truck and onto the ship at the port, and off the ship and onto a truck at the next port. All this manhandling made shipping costs too high for low-valued goods, such as lead-painted toys from China. But now the toys, lead and all, can simply be loaded into a container in a remote area of China and never touched again until they reach a Walmart warehouse in a remote area of the United States. This means that the lowest paid workers in the most remote parts of the world can compete with the working man down the street. And all of this is made possible by cheap energy.

The shipping container is here to stay, but not so cheap energy. That long ride from Sichuan to Beijing, that long voyage from Beijing to Los Angeles, that long trip from LA to Arkansas is becoming prohibitively expensive. The net effect should be to make American-made goods cheaper relative to foreign goods. And that's good for America. So, is the run-up in oil prices good or bad for America overall? The truth about any price is that it should not be high or low, but that it should be right. What is the right price for any commodity? It is the price that adequately compensates all the labor used up in its production, (including the “stored-up” labor known as “capital”), and that it account for all the “externalities” of the commodity. Now, the production costs of oil are very low. It costs the Arabs about $9 to raise a barrel of oil to the surface. Even adding in the handling and shipping costs, one can still make a nice profit at $120. So it would seem that the price is too high. On the other hand, the externalities of oil are very high. Obviously, there are the costs of pollution, but there are also other external costs: the cost of armies stationed abroad and wars to protect remote supply lines; the cost of highways, the least efficient form of transportation. Cheap energy has made possible the automobile, which has changed the shape of cities, or rather made cities somewhat shapeless and sprawling. This has imposed tremendous infrastructure costs on cities, costs which they have difficulty recovering. And many more things could be added to this list of externalities.

The answer is, then, that from the standpoint of economic rent, the price is too high, and from the standpoint of economic externalities, the price is too low. So what policies should be followed in a “too high/too low” situation? One answer is given by those who want to follow the European model, by which gas is already taxed to the point of being twice the cost it is here in America. This model has some success, in that the Europeans drive smaller cars and drive them less because they live closer to work and shopping. Even naïve libertarians like Charles Krauthammer have endorsed this solution. But I believe this European/Libertarian solution to be too crude and too government-oriented to be what we need now.

Hillary Clinton and John McCain are taking the opposite tack, at least in the short-run; they want to lower the taxes on gasoline. McCain's proposal really means that he wants to borrow more money to buy votes; Clinton at least wants to finance the cut with a tax on the oil companies, who can well afford it. And everybody has their own private palette of long-term solutions, some good, some dubious: more conservation, more drilling, more nukes, more carbon-taxes, more mileage standards, more ethanol, more ANWR. These solutions are indeed long-term, and will do little in the short-run. But since this is a game anyone can play, allow me to offer my own menu of solutions, solutions which address both the “too high” and the “too low” aspects of the problem.

Gas is Too High (Economic Rent)

It is beyond question that the high profit margins of the oil giants represents an economic rent, and such rents, or at least some portion of them, can always be recovered through the tax system without negatively affecting the economy. See (Taxes: Advice from Adam Smith). Some will argue that taxing the excess profits will reduce incentives. However, this argument ignores the fact that incentives, like every other economic quantity, are marginalized; that is, they are subject to the law of diminishing returns, one of the most basic of all economic laws. At some point, an additional dollar in incentives will not lead to an additional dollar invested in drilling, and the next dollar in incentives will actually lead to fewer dollars invested. Excess profits, when they truly are excess, when they truly constitute an economic rent, can safely be taxed. Further, it is far more efficient to collect the gas tax at the producer level than at the retail level. Hence, we can transfer the tax at the gas pump to an excess profits tax, and get the same money (or more) at a lower collection cost, and less aggravation to nearly everybody, except for a few oil company executives.

Some will argue that this will only increase the incentives to drive more and waste more, and they would be right, if it is not coupled with measures to address the externalities.

Gas is too Low (Externalities)

The most important thing is to end the system of subsidies known as the “freeways.” Roads should be funded by tolls, as I have argued previously (see Free Markets, Free-ways, and Falling Bridges.) This places the cost of remote living on those who wish to live remotely. More power to them, but don't ask the rest of us for a subsidy. The toll makes the gas tax unnecessary, to the extent that the tax is used to fund roads.

Mileage Standards are needed, but not as a set of bureaucratic diktats enforced by ever-growing bureaucracies. They can more easily be enforced by a system of consumption taxes and subsidies paid at the time of the purchase of a car. For example, suppose that the government sets a target of 35 MPG. A car that is judged to meet the standard would neither be taxed nor subsidized. But one that got only 25 MPG would pay a steep luxury tax, and one that got 40MPG would get a rebate. Those who insist on buying the biggest Hummer they can get will be taxed to support the more frugal driver. Think of it as a cap-and-trade system of carbon taxes for the common man. As it is, the cap-and-trade advocates only like it when it can be used by corporations. But if it is good enough for Dow Chemical, it is good enough for all of us.

The same principle can be used for anything that consumes large amounts of energy: furnaces, hot water heaters, appliances of all sorts, etc. Suddenly, there will be real economic incentives to buy the most efficient products, and disincentives to waste energy. And the same thing can be done for home energy costs: end all the taxes on energy bills, but place high luxury taxes on high users. Those who want to cool their homes to 60 degrees in the summer and warm it to 80 in the winter will pay a high premium to do so, while those who combine modest heating with warm clothing will see a reduction in their bills. Note that all of these taxes are avoidable to the extent that high energy usage is avoidable. Those who are responsible are rewarded, and rewarded without extensive bureaucracies. Those who want to live large will pay much, and more power to them. But in both cases, people are free to make a choice, even if we use public means to influence the choice.

I believe these principles will completely change the energy markets as we know them, and make the whole system more economically efficient. Nor do they require great social changes and high investments for them to be immediately effective. However, they will encourage great social changes in a relatively short period of time, changes that will be of great social and economic import.

The sages at Lehman's are predicting $200/barrel oil, and T. Boone Pickens has picked $150 as his target. Now, I am in no position to quarrel with these worthies, but I suspect that oil will actually drop 10% or 20% before it rises. But even if it drops, it will still be expensive, and that is not something that is likely to change in the current state of things. High oil prices can actually be good for the economy; they can actually increase our domestic production, while making alternatives cost-effective. And they can fund all sorts of new industries. It is not the price of oil that is the problem, but how we respond to it, or fail to respond.