Insurance against oil shocks: the best idea Bill Frist ever had

Back in 2006, there was a brief stir over the Republican majority’s plan to offer $100 rebates to offset higher prices from gasoline. It quickly became the object of almost universal derision, earning scorn from politicians and bloggers of both the left and right.

Kevin Drum, for instance:

A hundred dollar rebate! It’s bad economics, bad policy, bad optics, and the palpable stink of election-year desperation all rolled into one fetid package. But at least it’s means tested!

On the conservative side, Power Line asked “Wasn’t there a time when Republicans knew something about economics?” and proceeded to demonstrate its own ignorance of economics:

Taxes are a large part of the cost of gasoline. How about if we cut them?

Ironically, the rare proposal that managed to draw bipartisan condemnation was one of the best ideas Congress ever had.

First, why is one of the main alternative proposals—a cut in gas taxes—such a ridiculous idea? Since the US accounts for more than 20% of world oil consumption and the short-term supply of oil is highly inelastic (except when it’s in contango and oil is being hoarded), elementary tax incidence theory tells us that a substantial chunk of the gains from a short-term cut in taxes will go to producers, not consumers. In fact, a very short-term cut in the summer is even worse, since most of the supply is completely fixed, as refineries are already planning to produce as much as they can (which is what made Hillary Clinton’s 2008 proposal so absurd). On top of all this, gas taxes are presumably there to serve some purpose—in particular, to internalize some of the harm from congestion, accident, and pollution externalities—and that purpose doesn’t go away when the price of oil increases.

In short, cutting gas taxes in response to high prices is very bad policy. But that doesn’t mean there shouldn’t be any response from the government.

Of course, the US can’t repeal the laws of supply and demand: there’s no way to suddenly turn on the spigot and make oil cheaper in a world market where American producers will never provide more than a few percent of supply. An increase in oil prices will make Americans poorer.

But the problem isn’t just that an increase in prices makes consumers poorer. It’s that they have short-term liquidity problems: most consumers lack any cheap line of credit for when gas suddenly becomes more expensive. Instead, they have to cut other spending, even when the increase in prices isn’t expected to last forever—and that’s a very real inefficiency.

In an ideal, frictionless economic world, consumers would either buy insurance against high gas prices ahead of time or have easy access to credit, to make a sudden price change more palatable. In the real world, this doesn’t happen: the administrative costs of insurance are too high, and there are innumerable agency failures making it difficult to provide credit. When consumers are operating under these constraints, government intervention can be beneficial.

Frist’s $100 rebate proposal, though tiny, was a way to slightly ease the liquidity constraints facing consumers hit by price increases—in a sense, he wanted the government to provide insurance when the private sector could not. Of course, it wasn’t targeted to consumers who used the most oil, but that was unavoidable. Without any preexisting arrangement, the only way to provide targeted relief would be to cut the gas tax, which for all the reasons I’ve already covered would be a horrible idea.

Such relief could be made much more effective, however, if we made it part of a formal insurance system. Imagine the following: every year, taxpayers filling out their 1040s are given the option to purchase a limited amount of insurance against a surprise increase in oil prices. (The insurance is priced by government economists based on data from futures markets—in fact, the government can even take an offsetting position to negate its risk.) Naturally, anyone who is especially susceptible to an increase in prices will want to buy the most insurance—for instance, a commuter from the exurbs, or a New Englander whose house requires heating oil. This way, the government delivers targeted relief without the perverse incidence of a tax cut.

Whenever government intervenes in a market, of course, the natural question is to ask what advantage government has in providing the service. In this case, I think the answer is obvious: since the government already administers taxes, the overhead from offering oil price insurance consists of little more than an extra line on tax returns, some wire transfers (when the insurance is paid out), and maybe some checks in the mail. The government’s scale is so enormous that its cost of conducting trades to hedge the risk is minimal (and next to the size of its budget, the risk is minimal anyway). There are no regulatory barriers to navigate, and no costs to advertise the new program.

I can’t see why this has never been proposed.

In the absence of a more systematic program, however, ad-hoc insurance like Frist’s doomed “gas rebate” is a completely reasonable idea. It’s revealing that the proposal was so roundly mocked as bad policy—lawmakers and pundits relied more on the vague sense that a rebate sounded gimmicky than on any serious economic analysis. Republicans immediately pivoted to the their “real solution” (pretending that domestic supply can change world prices), while Democrats did the same (using CAFE to force consumers to buy efficient cars). And a perfectly valid proposal skidded to failure.