Saturday, July 12, 2008

Feldstein on Oil

"Although most experts agree that financial speculation was not responsible for the surge in the global prices of food and energy, many people remain puzzled about the source of these remarkable price rises. Economics offers a simple supply-and-demand explanation and reason for optimism about the future of commodity prices. In the case of oil, economics also suggests how policy changes today that affect the future could quickly lower the current price of oil. ... In the short run there is little scope for increasing the supply of corn in response to a global increase in demand. ... In reality, the picture is complicated by the substitution in both supply and demand among different agricultural commodities, and by the role of the corn ethanol program. But the basic explanation holds: With a very low short-run price sensitivity of demand and little scope to raise supply in the short run, even a relatively small increase in corn demand by the high-growth economies can lead to a very large short-run rise in the price of corn. ... Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise. ... But the fundamental insight is that owners of oil will adjust their production and inventories until the price of oil is expected to rise at the rate of interest, appropriately adjusted for risk", my emphasis, Martin Feldstein (MF) at the WSJ, 1 July 2008.

I agree with MF's analysis, but disagree with his policy prescriptions, i.e., "increases in government subsidies to develop technology that will make future cars more efficient, or tighter standards that gradually improve the gas mileage of the stock of cars". I oppose subsidies. Period. I favor these goverment actions: stopping Helicopter Ben's assault on the dollar, which will increase oil producers incentive to sell oil for dollars and adopting a "gas guzzler tax" in lieu of CAFE. The tax would work as follows: assume a car has a 150,000 mile life. With average gas consumption of 25 mpg, it uses 6,000 gallons over its life. No tax. If a car gets 15 mpg that's 10,000 lifetime gallons, and its purchaser pays $4,000 tax, $1 x (10,000 -6,000); if a car gets 30 mpg, the purchaser gets a $1,000 credit, $1 x (5,000 - 6,000). This reduces more fuel efficient cars relative cost and eliminates CAFE's perverse incentives for manufacturers. CAFE uses "average" fleet mileage as opposed to an attempt to change consumer purchasing habits at the margin. See also my 31 May 2008 post.

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