The Perils of Price Stability

If I had seen last Friday's New York Times op-ed on "Praying at the Pump" earlier, it might have preempted my thoughts on European fuel economy standards. The author, a former Clinton Administration official, makes a very well-reasoned, contrarian argument that our biggest energy problem is not our vulnerability to unstable foreign oil suppliers, but the economic consequences of oil's inherent price volatility. He goes on to suggest that even a large and successful effort on domestic oil substitutes would not be sufficient to insulate us from the influence of the global oil market. That's counter-intuitive, but probably right. His op-ed contains many good insights, so it's a shame that I can't agree with Mr. Minsk's ultimate conclusion. By setting oil price stability as the ultimate goal of good energy policy, he mistakenly dismisses the benefits of freely-functioning markets and ignores much of the history of artificially-stabilized energy prices.

This argument might all sound rather esoteric, but I believe it is of more than academic interest. Our growing concern about climate change is likely to result in a major energy market intervention, whether in the form of an emissions cap-and-trade system or a carbon tax. It is crucial that in the process of recognizing the environmental externalities of our oil use, we should not impede the ability of the market to respond rapidly to changes in supply and demand.

There are two basic problems inherent in any effort to stabilize oil prices. The first is the one that every first-year Economics student learns: prices are the means by which supply and demand are re-balanced, when supply or demand change. We've seen this demonstrated in the short run, when price increases after Hurricanes Katrina and Rita prevented catastrophic runouts and long gas lines. We've also seen it work in the longer term, when higher oil prices from the mid-1970s to early 1980s--even after being filtered through federal gasoline price controls--promoted enough efficiency to break OPEC's hold on the market within 10 years. And we've seen the result when prices weren't allowed to adjust quickly enough in the late 1970s: gas lines and non-economic rationing.

The other problem with enforced price stability is that once you create its mechanism, you have to decide at what level to stabilize prices. While I suspect the future prices to which Mr. Minsk alludes are meant to be stable and high, it might not work out that way. The political temptations to stabilize at lower-than-market levels would be enormous. In the mid-1990s, when I looked after Texaco's interest in its Caltex alliance in Asia-Pacific, several of the countries in the region had "oil price stabilization funds", including Korea and the Philippines. Originally intended to buffer consumers from the fluctuations of the market, they ultimately subsidized consumption, contributing to rapid demand growth that outstripped local refining capacity. That led to higher petroleum product imports and a wave of premature and unprofitable refinery construction and expansion. The lesson here is that when you control the price of something the whole economy depends on, you are effectively controlling the economy.

We've seen this effect closer to home, as well. Regulated electricity prices are a model of stability, with consumer prices set by state regulators after public hearings and impeccable justifications. But while everyone now seems to blame the California energy crisis of 2000-2001 on Enron and other traders manipulating the new electricity market, the deeper problem was that the so-called deregulation did not unfetter consumer prices. As a result, utility customers never got the signal that the state was out of spare generating capacity, until wholesale prices reached astronomical levels, putting one--and nearly both--of the state's largest utilities into bankruptcy.

Now, I'm not sure that Mr. Minsk had the creation of an oil price stability fund in mind; he certainly never mentioned one. But there are only so many ways to stabilize prices without controlling them. We could try to create a large supply surplus, either by accelerated efficiency measures to dry up demand, or with lots more oil drilling. Either of these paths would take time, though, and patience isn't our greatest virtue. Once we got our minds set on oil price stability, I suspect we'd find a way to create it, no matter what the consequences--anticipated or otherwise. So while more stable oil prices and the economic benefits they would bring might be a valuable by-product of good energy policy, elevating price stability to a higher priority than reducing imports or cutting greenhouse gas emissions would be distinctly counter-productive.