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.

Is there a macroeconomic rationale for higher gas taxes?

Several of my favorite bloggers like to argue that the macroeconomic effects of oil shocks justify higher taxes on oil, to bring down overall consumption and the harm from future shocks. While I agree that oil should be taxed at a higher level, I’m not sure that this provides a convincing rationale.

First of all, we need to be clear about why oil shocks have an effect on the economy. To my knowledge, there are three main possibilities:

1. As consumers spend more on oil, they spend less on other forms of consumption, thus lowering output.
2. Higher oil prices make the production of certain goods uneconomical, and there is an optimizing shift away from these goods, possibly lowering overall output.
3. An increase in oil prices raises inflation fears and pressures the Fed into adopting a tighter policy.

Though #2 is certainly a possibility, it doesn’t offer any clear reason why we should raise the gas tax. After all, the entire point of the price mechanism is to encourage consumption when costs are low and discourage it when costs are high. Someone investing in a factory that requires oil inputs does so in full awareness that future oil increases might render her investment unprofitable. To justify adding an additional disincentive to using oil, we need to identify some kind of externality from this decision, or interaction with a market imperfection. And while there are certainly externalities from pollution and congestion, a purely macroeconomic externality seems hard to identify.

Possibility #3 is more plausible. But as Charles Evans, president of the Chicago Fed (and a monetary economist of some repute), points out in a a recent article, it is quite difficult in the post-Volcker era to identify either a substantial response in monetary policy or an response in inflation to an oil shock. The increase in prices shows up as a one-time uptick in the headline CPI, of course, but does very little to influence future inflation. As Evans observes:

The modest dependence of policy on energy and other commodity prices implied by our analysis is not surprising. The shares of firm costs accounted for by energy and commodities are not large and, in fact, have fallen over time. Moreover, at least in the case of oil, price increases tend to slow the economy even without any policy rate increases. Of course, if commodity and energy prices were to lead to a general expectation of a broader increase in inflation, more substantial policy rate increases would be justified. But assuming there is a generally high degree of central bank credibility, there is no reason for such expectations to develop—in fact, in the post-Volcker period, there have been no signs that they typically do.

Ultimately, the need for the Fed to offset the rise in inflation following a surge in oil prices is very small—because there isn’t much of a rise at all.

Of course, this doesn’t prevent crazy people from using commodity prices as a justification for tight policy, and to the extent that Fed decisions are influenced by such individuals it’s possible that oil shocks are macroeconomically corrosive in practice (even if they shouldn’t be in theory). But then the macroeconomic justification for gas taxes rests mainly on the idea that monetary policymaking is poorly implemented—and if we’re talking about an idea as politically difficult as increasing the gas tax, we probably want to consider the more direct step of making monetary policy more effective. Regardless, given the relatively small influence of commodity prices on monetary policy in the last few decades, the case here for a significantly higher gas tax appears limited.

Finally there is possibility #1, which is the most common intuition for how higher oil prices impact the economy: when consumers are spending more money on gasoline, they have less money to spend on everything else, and output declines.

It’s important to realize that this story is not as straightforward as it seems. When consumers spend more on imported oil, there are two possibilities: either (1) exports increase and the current account deficit stays the same, or (2) the current account deficit increases. In case (1), the rise in exports means that there isn’t a direct hit to output. With (2), meanwhile, we have to remember that the inevitable correlate of a current account deficit is a capital account surplus. To exactly the extent that a oil shock causes imports to rise above exports, there is a rise in the flow of capital into the United States. Since the financial system isn’t perfectly frictionless, this capital inflow won’t necessarily be directed to the consumers forced to cut back by higher oil prices—but it will ultimately end up with someone, and there is only a macroeconomic effect to the extent that the “someone” is less likely to spend than the consumers and businesses paying more for oil. While this is completely plausible (after all, credit constraints are everywhere), it’s not clear that the magnitude is large enough to justify much of a tax.

It’s even harder to see the externality here. A consumer who buys an SUV is probably aware of the fact that higher gas prices will cause him trouble in the future—you don’t need to be hyperrational Economic Man to say “hey, the last time gas was at $4 a gallon, I had to cut back on some other spending, and it wasn’t much fun”. To the extent that government adds a tax on top of this, it’s making the incentive to avoid spending on oil even larger than it should be.

Perhaps in a liquidity trap there’s some macroeconomic spillover. But that brings us to a key point: commodity prices are highly procyclical. Though they fluctuate for many reasons, they tend to decline tremendously during a severe recession, which arguably makes them a stabilizing force during times of economic distress. It’s easy to imagine this effect overwhelming all the other macroeconomic consequences of oil—after all, a recession is precisely the time when credit constraints (which are the mechanism through which short-term commodity price changes have an influence on other types of consumption) are most binding.

In the end, therefore, it’s not clear that oil price movements are destabilizing at all, much less destabilizing in a way that justifies a preventative tax. There are many reasons to tax gasoline, but macroeconomics isn’t one of them.

Why do voters care most about the prices politicians can’t change?

Every day, there’s a new story about the political importance of gas prices. Apparently, voters jump to blame their leaders (especially the President) whenever they’re facing high prices at the pump.

Of course, this is complete nonsense. There is virtually nothing that American politicians can do to change the price of oil. Mitt Romney talks about the need to keep “supply” in line with demand, but he neglects to mention that the relevant quantities are world supply and world demand, and that the US has nowhere near enough oil to make a dent in world supply. Although producing more oil would be financially beneficial for the US, this is only for the very simple reason that selling oil earns money, not the tiny impact that higher US production would have on prices faced by consumers. (Norway has probably managed to figure this one out by now.)

At the same time, however, there is an even more important price that politicians around the country can change: the price of housing. Especially in major cities like New York, San Francisco, Washington and (gah!) Boston, a tangle of zoning and building restrictions makes housing far more expensive than the direct costs of supplying it would suggest. Changes in population from state to state are dominated by a general trend of moving to where housing is cheaper. The costs of shelter account for more than 20% of consumer expenditures. Clearly this a very, very important issue for consumers’ well-being—yet we don’t see a popular response that comes close to matching the ferocity of the reaction to gas prices.

To be fair, there is some response, and it usually takes the form of misguided measures like rent control or top-down efforts to provide “affordable housing”. But I think it’s fair to say that housing is, most of the time, much less salient as a political issue than energy.

Why is this? The obvious explanation is that richer and older people—the ones who vote—are disproportionately more likely to be homeowners. According to the Consumer Expenditure Survey, 89% of the top quintile are homeowners, compared to 40% of the bottom quintile. If we look at the data by age, roughly 80% of households led by people 55 and older own their own home, versus 14% for households led by someone under 25. Homeowners, of course, generally benefit from an increase in housing costs: they own an asset whose price reflects both housing costs today (which they have to pay whether or not they own a home) and housing costs in the future. Since most homeowners are going to die long before their houses or land become uninhabitable, an increase in those future housing costs leads to a direct increase in their real wealth. (Unless, of course, they care about their great-grandchildren’s wealth just as much as their own.)

Perversely, their incentive is to choke off the housing supply as much as possible, not look into ways to create affordable housing. And now, in a world where higher house prices are (mistakenly or not) viewed as essential to economic recovery, this manipulation even acquires an air of legitimacy.

With energy prices, on the other hand, there’s an element of politicians creating their own reality. Since energy encounters price spikes so frequently, it’s an obvious target for popular anger, and thus an easy target for political pandering. Even if there’s absolutely nothing they can do on the issue, politicians are forced to say something about it. And since politicians talk about energy prices so much—and those prices become perceived as a legitimate topic of political debate—voters assume that government must be able to have some impact.

Meanwhile, hardly anyone in the US—save for Alaskans and investors piling into Exxon Mobil stock—benefits from high energy prices. It’s hard to imagine anything less politically risky than complaining about the price of gas. And so we’re left with a bizarre distribution of political attention: massive coverage of a less important price that we can’t change, but relatively minor interest in a more important price that we can.