Gas Prices: My Mental Battle Over Two Views

May 30th, 2011 at 8:12 am

Last Friday, I was talking gas prices and their impact on family budgets and the wider economy on MSNBC (link coming when/if available) with host Matt Miller and economist Peter Morici.

I was again struck by the two competing views that I, and I suspect others, hold in their heads on this issue.

Even though I’m one of those economists who see market failures hiding around many corners, I still think it’s extremely important to pay attention to price signals.  (It’s crucial that those signals are accurate, of course—a quick explanation of the housing bubble/financial crash is that risk was severely underpriced).

And when gas prices rise as much as they have over the past year, the market is sending an important price signal that we need to get serious about conservation, alternative (renewable) energy sources, and so on.  I believe we should heed this signal and act accordingly.

But then there’s this: middle and low-income households are getting stung by higher energy prices at a particularly bad time, and it’s pinching their already constrained family budgets.  This hurts them and it hurts the fragile economic recovery.  Neither is it realistic to believe that everyone can conserve their way out of this, by quickly changing their driving habits or shifting to higher mileage, or even electric, vehicles (check this out).

As I’ve noted in recent posts, thanks to the combination of stagnant earnings’ growth and faster inflation (itself largely driven by energy costs), real paychecks have been falling.  And according to BLS data, the average, middle-income family spent about $2,000 a year on gas last year.  Since then, prices at the pump are up almost 40%, meaning that if folks eat the whole increase, that’s another $800 tacked onto the family budget.

Now, there’s an elasticity in play here, which is just to say that people will sometimes buy less of something when the price goes up.  But when it comes to gasoline, at least in the short run, people tend to suck it up and just pay most of the difference (gasoline is “inelastically demanded” in the short run).

[I’ve seen some suggestive evidence that we may, in fact, be getting better at responding to higher gas prices more quickly.  If this response is truly becoming more elastic, it’s very important and if there’s an econ grad student out there listening, I just gave you a great dissertation topic…you’re welcome…keep me posted.]

One interesting point here: if you sum up all the extra money we’re spending on gas thanks to the recent price spike, it looks like it’s going to amount to around $100 billion this year.  That’s about the same aggregate amount that the payroll tax cut agreed to last December is putting into people’s paychecks.  So in that sense, the increase in at least somewhat offset, at least for working families.

But other than tapping our strategic reserves, which aren’t really for market driven price movements (it’s supposed to be for big, temporary shocks, like Katrina—though it’s true the “Arab Spring” revolutions are playing a role here, I don’t think these warrant tapping the reserve now), there’s not much we can do to lower the price in the short run.  It’s a truism in economic policy that it’s tougher for government interventions to address supply relative to demand-side contractions.

And again, do we really want to jam this market signal?

At the end of the day, as President Obama (very courageously, I might add) recently said, we’re going to have to get used to higher gas prices.  Any offset ideas could only be temporary, and the reality is that there’s probably nothing much we can do to alter the price of fossil fuels in the long run.  Physical resource constraints combined with the price and availability of alternatives will determine this.

As I said on the TV, maybe the best way to resolve the mental conflict I’m suffering is to think about policy actions that both create good jobs for middle class workers while building up a domestic clean energy sector.  Again, it won’t happen tomorrow, and thus won’t do much for those of us paying $75 bucks this weekend to fill up the minivan to get to the kids’ soccer tournament, etc…

And they didn’t even win.

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15 comments in reply to "Gas Prices: My Mental Battle Over Two Views"

  1. Greg Worley says:

    How, in your thinking, do you factor in the possibility of market manipulation? I ask this because some credible folks (well, Goldman Sachs is among them, but still …) have indicated that as much as 30% of the run-up in oil prices is due to speculation on the futures markets. That and the curious phenomenon of prices at the pump reacting immediately when crude goes up but lagging significantly when crude prices go down.


    • Jared Bernstein says:

      Many good questions in this AMs comments and can’t get to them all right now…I’ve got the unenviable task of cleaning a grease-soaked grill.

      But wanted to add an important concept here: the market manipulation point will take more thought/explanation…there’s a fine like between normal and excessive speculation. But the phenomenon you describe re price movements at the pump is something folks have noticed. We call it “rockets up, parachutes down.” And it is…um…curious.

      OK, time for some real work.


  2. Jeff H says:

    In addition to what Greg noted above, in 2008, after the crash of Lehman/AIG/F&F… the price of oil crashed, and the price of gas crashed.

    Gas hit pre Katrina lows, in SoCal it was under $2. I have heard many economists claim that the crash caused a crash in demand world wide. I want to call BS on that claim, and say what everyone should have said, it’s speculation plain and simple. Sure, lots of people lost jobs and didn’t drive as much, but not immediately, and that does not explain the prices falling levels they held for a decade before Katrina.

    When the money dried up, post crash, pre TARP, the price of oil fell to it’s “natural” level, $20-$40 a barrel.

    We love to blame big oil, or Saudi Sheiks, but though they certainly influence the price, and they most certainly gain from high prices, they are no longer the driver. Post Katrina it seemed Wall Street stepped up their market presence in commodities. Considering the only time prices returned to pre Katrina levels was when Wall Street had to sit out commodities trading is the proof in my pudding 😉

    What say you?


    • Kevin Rica says:

      Jeff,

      In 2008 the U.S. economy (world’s biggest oil user and importer) went into a recession and oil consumption plunged an astonishing 10%.

      The same pattern was repeated around the world. Now China and many developing countries are recovering and they are the major new source of demand. Supply isn’t keeping up. That’s a textbook supply and demand story.

      That is not to say that speculators can’t drive up oil prices. They can! But when they do, inventories should be increasing. When the inventories don’t back the speculation story — you need to look for some other explanation.

      Right now, inventories are falling, so the simple explanation is the best — China’s imports are growing hand-over-fist and oil production is not growing much at all. Supply and demand.


      • Jeff H says:

        Kevin, I don’t think that explains the large swings in price. It might explain slower increases and decreases, but with the use of “paper barrels” it’s not necessary to work with real inventory, just the “paper inventory”.


        • Jeff H says:

          BTW, after writing that I realized, no one seems to think that the ENRON effect is still possible. Did we ever do anything to prevent it?


        • Kevin Rica says:

          Jeff,

          To an economist, the business and inventory cycles explain explain lots of things. You are free to come up with your own explanation beginning with Masonic conspiracies.

          However, I’m curious, explain the mechanics of your paper barrels theory?


          • Jeff H says:

            Kevin,

            I heard the term paper barrels from a few sources, it certainly isn’t my term. 😉

            Essentially, a paper barrel is a barrel of oil that is bought, then sold by an entity that will never see the barrel of oil.

            So, if you look at the commodities market, and you see a dramatic fall in oil price, then look at who holds what positions, and for how long, you will see that paper barrels are at the root for the violent swings.

            It used to be airlines, heating oil companies, and others that need to deliver or actually use the oil were the ones using the market to maintain constant margins. But, since Enron the commodities markets have been extremely volatile.

            That’s why I made the point about the crash in 2008. Remember what the price of oil was in the summer of 2008? $140+ I believe. Then when Lehman/AIG/F&F went belly up, the price landed over $100 less.

            That certainly had nothing to do with business cycles. Nor did the recent one day drop a few weeks ago have anything to do with the business cycle.

            Come to think of it, we just had one of the beginning of summer Memorial Day holiday weekend. Usually the start of the highest gas prices, which are actually supported by business and inventory cycles.

            What happened prior to last weekend? I don’t know where you live, but in California the price of gas over the last month has gone from $4.29 a gallon for regular to $3.85.

            Business cycle? Inventory cycle? Did the world start working in reverse?

            Speculation, plain and simple. I think the price drop has more to do with the hammering the regulators took in the senate over not regulating positions in the commodities market than any business cycle.

            Thanks
            Jeff


  3. Kevin Rica says:

    Jared,

    Isn’t that the problem with “alternative energies?” At a time when food prices are going through the roof, we pay people to convert food into a gasoline substitute. (The food that it takes to fill a hummer with ethanol is enough to feed 2 Senegalese for a year — but only drives the Hummer 2/3 as far.)

    Oil and coal companies at least pay some taxes and royalties, and produce — enormous amounts of energy. Selling that energy is their revenue source. No government agency requires you to buy gasoline — you buy it because it’s energy and energy, the physicists tell you does work, (it moves your car).

    Alternative energy companies don’t actually produce much energy. (Check for yourself how much wind, solar, and geothermal produce in the great scheme of things: http://www.eia.gov/totalenergy/data/annual/txt/ptb0103.html ) And generally the energy that they produce is intermittent (unreliable). You have to force utilities to buy it or just pay most of the costs if you want utilities to produce it. It’s not that utility companies like to pay money to coal companies (they don’t), but they make money selling electricity and alterative energy just doesn’t produce much to sell — and huge government subsidies can distort prices — but cannot produce much useful energy.

    And at the end of the day, when gasoline prices to up, we have to pay because what alternative energy companies produce is not an alternative to gasoline.


  4. apishapa says:

    50 million of us did not get a tax break. I am a public employee. My taxes went up in January – not down. It is wrong to pretend that cutting Social Security is a tax break for all of us. It is not. My gas prices are up. My health insurance is going up by almost 30%. The cost of food is going up.

    The tax cut last year which Obama passed was much more fair and sensible. Why on earth did we need to go backwards take away that tax break for all Americans and take money from Social Security? Because Republicans needed to be able to say Social Security is not paying its way. We hear all year that we need to cut benefits on seniors because Social Security is going broke, so what does Congress do? Cut Social Security taxes, and start whining about needing to cuts benefits on my mother.


  5. David Welker says:

    Nice post.

    I agree that the high gas price status quo is painful but also incentivizes a move away from excessive oil dependence. An interesting and related story in CNN is how Saudi Prince Al-Waleed bin Talal was advocating on Fareed Zakaria GPS for lower oil prices. His concern is that higher prices might create an incentive for the West go find alternatives to oil.

    I think in this case our long term interest might be in conflict with our short term interest. In the long run, we may be better off with a higher cost of oil precisely because it gives American companies an incentive to develop alternatives. In the short run, it can be difficult to handle, especially for households whose budgets are already very tight.

    I think the complicating issue here is the economy. While the economy is weak, it is even more difficult for people to handle higher gas prices than it would be otherwise.


  6. Jason says:

    Jared,

    How about blaming the speculators? They are the criminal in all this. Can you speak to that? Or are you too hamstrung by the speculators ?


  7. Namrata says:

    Good Morning,

    Nice post and some food for thought. Considering the current furore over the importance of denuclearisation, it could be interesting to see any information/ input you may have on future oil prices while also accounting for nuclear energy reduction in the coming years.

    Another observation from the Middle Eastern neck of the woods: I have been an expatriate resident in Oman for over two decades and at least in most of the GCC region, demand for oil in the short run does not seem to be becoming more elastic. On mulling over this, the following possible causes came to mind:
    a. While countries like Oman wax eloquent about economic diversification, alleviating oil dependence and adopting alternative sources of energy, the prices remain highly subsidised (one litre in Oman currently averages at 0.12 OMR (1 USD = 0.385 OMR), so unless there was a drastic price increase, demand would be likely to remain the same.
    b. Another reason is the ‘conspicuous consumption’ effect. The consumer mindset in these parts seems to allocate a very high priority to status symbols such as flashy cars and school teachers take loans to buy ferraris. Logically speaking, if people are willing to spend so much more than they can actually afford on a car, wouldn’t they continue to their vehicles extensively even when oil prices rise?

    Would appreciate your feedback.

    Thank you.


  8. TC says:

    Hi Jared,

    “Now, there’s an elasticity in play here, which is just to say that people will sometimes buy less of something when the price goes up. But when it comes to gasoline, at least in the short run, people tend to suck it up and just pay most of the difference (gasoline is “inelastically demanded” in the short run).”

    You are one of the few people who have noticed this. I make a strong case that energy and gasoline prices should never be a concern of the federal reserve due to low elasticity in the price of oil. Check out this post:

    http://traderscrucible.com/2011/03/08/the-real-reason-to-ignore-energy-inflation-when-core-inflation-is-low/

    We have zero impact on gasoline prices with our monetary levers. Only the most draconian monetary policy would even dent demand at all. Any monetary cure for high gas prices would be far worse than the disease.

    You probably also noticed the IMF recently came out with far lower elasticity estimates over both the short and long term.

    http://traderscrucible.com/2011/04/26/the-hyperinflation-hoax-is-worse-than-we-thought-we-cant-change-the-price-of-oil/

    I approach this from the point of what to do with monetary policy, but the point is the same.

    Great blog! I used to cheer every time you came on CNBC! Keep up the good fight.


  9. Richard M. Mathews says:

    To understand how to get lower gas prices, you need to understand why they have been low in the past. It is true that gas prices have historically been quite inelastic, so the price should have been high all along. What has kept the price down has been the fear of alternative energy sources for cars. (This means things like batteries, hydrogen, and ethanol. Things like wind, solar, or geothermal only come in to play as sources of electricity to charge batteries.)

    Oil producers want to keep us addicted to oil until the last drop of oil is pumped from the ground. If we switch to alternative energy sooner, they are stuck with oil they can’t sell. It is this long-term competition with alternatives that keeps oil prices in check.

    When we had oilmen as Pres and VP and a Republican congress, oil prices soared at about 20% per year. There was no chance that the United States would invest in alternatives with those people in power. Oil prices could rise without fear of competition from alternatives.

    An incredibly serious collapse of the economy at the end of the last administration brought oil prices down, but an important change also came about with the shift to a Democratic administration and congress. Instead of large annual swings in gas prices superimposed on the 20% per year increase, we saw an amazing period of oil price stability. From June of 2009 to November of last year, U.S. gasoline prices barely changed.

    What happened in November? We went back to a congress that has no chance of investing in alternative energy.

    If you want to make a difference in gasoline prices, in both the short and long term, start making some big government investments in alternative energy, and threaten to keep increasing that spending as long as gasoline prices are high. Fund it with a surcharge on new cars in proportion to the expected gasoline use by the car over 100,000 miles (this avoids punishing those who have already made their car-purchasing decision and who, due to inelasticity, would not reduce their gasoline usage much in response to a gas tax).


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