If you ask a typical person what went wrong with the American economy in the 1970s, I think he’ll probably tell you the issue was that oil got very expensive. If you instead ask an economist, she’ll probably find the oil answer annoying and explain that it’s really all about monetary policy and central bank independence and Philips Curve fallacies.

But on some level, I think the issue really was that oil got very expensive. Not only do oil price shocks cause a lot of substantive problems, but they also force macroeconomic policymakers to make decisions with a lot of ugly, no-good options. It’s easy to second guess in retrospect the decisions of people who had no good options, but the fact is that energy scarcity is just really bad.

Consider that while the Bureau of Labor Statistics reported an overall year-on-year inflation rate of 8.3 percent for April (which is a lot), the increase in prices for electricity (11%), piped natural gas (22%), gasoline (43.6%), and fuel oil (80.5%) were all dramatically higher than that.

This doesn’t mean that current inflation is all about energy; it means that energy scarcity would be a huge economic problem even if we tamed overall inflation. The BLS publishes a “core” inflation series that excludes food and energy prices so that policymakers can get a better sense of the underlying macroeconomic situation separate from commodity price fluctuations. That ran at 6.2 percent in April, which is obviously above the Fed’s normal target of a bit over 2 percent.1

But imagine a world in which Democrats did a smaller stimulus bill and the Fed showed better judgment around FAIT and inflation was exactly on target today.

In a world like that:

Shelter prices would be up 1.1 percent instead of 5.1 percent.
Medical care services would be down 0.5 percent instead of up 3.5 percent.
Apparel would be up 1.4 percent instead of up 5.4 percent.
New cars would be up 9.2 percent instead of 13.2 percent.

That would all be nice, and I bet people would be pretty pleased. But if you apply the same math to the eye-popping prices in energy commodities, I think you can see that we’d still have a huge problem. The price of electricity and home heating (for the majority of Americans who use gas) would be rising significantly faster than wages, and the price of gasoline and home heating for people who use oil2 would be rising dramatically faster than wages.

This is to say that we’d still be stuck with a huge “inflation problem” even if macroeconomic policymakers did a perfect job. You’d have a lot of economists and pedants (here’s where I come in) explaining that the soaring energy costs aren’t really inflation and that if you look at the core index, things are fine. Then a lot of people would get mad at Jay Powell and posit various conspiracy theories about why he’s pretending there’s no inflation when gas prices are up by almost 40 percent.

We don’t live in that world. Instead, we live in a world where there really is an underlying inflation problem. But the point of considering the hypothetical is to remind everyone that there is a specific energy price problem that is actually distinct from the macroeconomic question of overall inflation — gas prices aren’t high because of ARP or because of FAIT, and the fact that they are so high is a real problem.

Expensive energy is really bad

High gasoline prices are obviously a good talking point for Republicans.

But over and above being a talking point, expensive energy is a genuinely very grave problem that serious policymakers should be trying to address on the merits, not just for which they are seeking political solutions.

Why is it bad? While energy consumption scales with income to some extent, it’s not like millionaires drive three times as much as the median American. People sometimes say that inflation is regressive, which I think is probably not true, but expensive gasoline is absolutely regressive, which means the direct consequences for human welfare are pretty dire. Beyond that, though, people treat their gas and utility expenses as quasi-fixed because altering them is hard. In other words, they respond to expensive energy by economizing on things that aren’t energy: by canceling a Netflix subscription, by skipping date night to avoid babysitting expenses, by making do rather than replacing a broken microwave. Indeed, fresh research suggests that a $1 increase in gas prices generates essentially a $1 reduction in non-gas spending in the short term.

The upshot is that even someone like me, whose gasoline expenses are very low and whose home electricity expenses are essentially zero,3 ends up suffering some economic hardship because it’s more difficult to sell newsletter subscriptions when everyone is watching gas costs drain their bank account.

What makes things really punishing, though, is that it’s not only households that have quasi-fixed energy costs — so do businesses.

So imagine you own a dive bar. You’re annoyed personally about how much more you’re paying for gas, but you figure it doesn’t have much to do with the bar business. Except your customers are a bit more frugal with their drinking since their wallets are lighter due to the higher energy costs. Not by a huge amount, but they are buying cheaper drinks and fewer of them. They’re also tipping less generously, which is annoying your staff. You also realize that the cost of air conditioning the bar in the summer is going up. Your revenues are heading down while your expenses are heading up, so at a certain point, it makes financial sense to curtail your hours because the slowest times in the week no longer pencil out.

And that’s a fairly trivial example. Someone whose business involves using a lot of gasoline — like the guys who deliver the beer to the bar — really needs to raise prices because their costs are exploding. Since this is happening at the same time that people are drinking less beer, it’s really bad for business to increase prices, but you’d be losing money driving the truck if you don't.

Stag whether or not you get “-flation”

Translating into economics-ese, from the standpoint of people running non-energy businesses, high energy prices are a negative supply shock.

If you open up an economics textbook, you’ll find a simplified chart like this showing that when an industry faces a negative supply shock, they sell less stuff and they sell it at higher prices.

High energy prices are a negative supply shock to almost every business you can think of. For some businesses, like smelting aluminum, it’s an incredibly bad negative shock; for others, it’s pretty mild. But while the economy can adjust from a supply shock to one sector, a supply shock hitting almost every sector simultaneously creates a really bad problem.

Higher prices plus lower quantities equal the dread stagflation of the 1970s.

But here’s the thing. Look at the chart and you’ll see the Fed could avert inflation by shifting the demand curve further to the left. The problem is that if you do that, quantity is going to fall by a much larger amount. So you could completely avoid the problems and failures of 1970s-style stagflation, but all that would mean is you have a really big recession. When you give policymakers a choice between “inflation and a recession or else no inflation but there’s a big recession,” well, that’s just not a very appealing choice. The question of what central banks should do in that situation is interesting, but obviously the best thing for society would be to avoid the problem in the first place by producing more energy.

This is worth taking seriously

Because Republicans are out of power, they are leveling a lot of nonsense attacks on the Biden Administration over the oil price situation.

It’s simply not the case, for example, that ESG investors are somehow responsible for American oil production not having yet recovered to pre-pandemic levels. Nor is the cancellation of the Keystone XL pipeline responsible for high gas prices. On May 12, the Biden Administration canceled offshore oil leasing in Alaska and the Gulf of Mexico which attracted GOP criticism. But it takes years for a new lease to generate new production. Right now oil companies are producing less than their existing rights would allow them to produce — the deficit is one of investment rather than drilling rights.

But while Democrats are right that most of the GOP talking points on this are shallow and ill-informed, I think it’s fair to say that the same underlying motive that lead progressives to call for canceling Keystone XL and offshore drilling leases impedes them from taking the energy problem seriously on its own terms.

Simply put, elite progressives are very worried about climate change to the point that I think they don’t take the problem of expensive energy seriously enough.

The official climate movement position is that it is possible to have a clean energy transition without generating a large structural increase in energy prices. And my assessment of the evidence is that the official position is correct. But just because it’s possible to increase your income by quitting your job and launching a subscription newsletter on Substack doesn’t mean that it’s a good idea to quit your job and launch a subscription newsletter on Substack. You need to assess whether you in particular have a plan that is likely to succeed. And I think it should have been obvious back in the winter of 2020-2021 that the Democratic Party did not, in fact, have a plan to generate so much vehicle electrification and zero-carbon energy over the course of calendar year 2021 as to make constrained fossil fuel supplies irrelevant by summer 2022.

And while we now have more electric vehicles — both cars and e-bikes — on the road than we used to and more renewable electricity than ever before, it’s not enough to fill the gap caused by American production having not yet fully recovered or the additional gap caused by American foreign policy successfully crimping Russian production.

If Joe Biden had put out a Day One executive order saying it’s the policy of his administration to promote a rapid increase in short-term U.S. oil and gas production and that he wants to direct every executive agency to produce policy options for doing that, it would have caused a lot of backlash from environmental groups. But he’d be in a better position today. Not because there’s an easy answer to the question, but precisely because it’s actually a hard problem, so it deserved time and attention and planning that instead went in the other direction.

Energy is too important for the market alone

In the progressive group universe, a lot of people at least claim to believe the following things:

World governments are going to achieve their stated goal of holding global climate change to 1.5 degrees of warming over the pre-industrial norm.
Achieving (1) implies a very rapid ramp-down of fossil fuel usage.
Since many fossil fuel projects have large up-front costs that are recouped over a long period of usage, (2) implies that many current profitable-looking fossil fuel investments will go bankrupt.
Because existing financial institutions do not appear to believe that (3) is true, they are creating a financial stability risk comparable to the reckless lending leading up to the 2007-2008 financial crisis.
Therefore, financial regulators ought to adopt rules that aim to constrain investment in fossil fuel projects.

This whole argument is a house of cards based on the clearly false first item. But I think the people who claim to believe in this “stranded asset” theory are aware that the argument doesn’t really make sense. What they actually think is the reverse argument — that (5) makes us more likely to get to (1).

Why would you adopt such a loopy approach to reducing fossil fuel consumption rather than doing something economist-approved like a carbon tax or a cap and trade program? Well, because progressive groups have learned that straightforwardly making energy more expensive is politically toxic, so you don’t want to lead with your chin. That’s a fine insight, but trying to use financial regulation as a backdoor carbon tax doesn’t solve any of the problems with a carbon tax — it just makes things worse:

A carbon tax generates revenue that can be used to alleviate the regressive nature of the tax or to finance useful new clean energy infrastructure or research.
A carbon tax harms all fossil fuel producers around the world, whereas the finreg approach uniquely burdens American producers while helping Saudi Arabia, Russia, Venezuela, Iran, etc.
A carbon tax approach increases prices in a predictable way, making sure that policymakers don’t accidentally raise prices by more or less than they intended and that other actors in the economy have the ability to plan.

To be clear, the Biden Administration has not embraced stranded asset theory as a matter of policy, but it is popular among some of his appointees, so the administration generally appears torn between trying to kneecap production and realizing that it’s a bad idea.

But the more plausible worry is actually the opposite of stranded asset theory: it seems like fossil fuels are not poised for long-term growth. The most recent investment boom ended in tears for everyone — in part because of bad decisions by investors, in part because OPEC tried to put them out of business, and in part because of the pandemic — so financial markets are trying to steer the whole industry toward shareholder payouts rather than re-investing. This is exactly what’s happened to the newspaper industry over the past 20 years as the private equity players who dominate the space have found it financially optimal to underproduce news relative to what’s good for society.

What is to be done?

I don’t have “one weird trick” for this the way that allowing imports and changing the guidelines would fix the formula crisis.

The Biden Administration would like Saudi Arabia to significantly increase oil output and bring down the global price. Saudi Arabia, it seems, doesn’t want to do that. This decision on their part completely subverts the basic logic of the U.S.-Saudi alliance, which is that we help them with their regional problems and in exchange, they are supposed to prevent a U.S.-Russia geopolitical crisis from crippling western economies. Why have the Saudis flipped on this? Narrowly, they are mad at Democrats over the Iran nuclear deal and because Democrats complained about them murdering Jamal Khashoggi. They don’t like Joe Biden and would be happy to have Trump back in office.

More broadly, back in December 2015, the Obama administration made a deal with congressional Republicans. The Republicans got an agreement to end the prohibition on exporting crude oil, and in exchange, the GOP agreed to extend various clean energy tax credits. Thanks to this deal, the U.S. became a net exporter of petroleum products and the clean energy boom continued even during Trump’s four years in the White House. But this was also a direct shot at Saudi interests, and though it took them some time, they eventually retaliated by teaming up with Russia (that’s the + in OPEC+) to engineer a global oil price war that caused a lot of U.S. fracking investors to lose their shirts.

Today, potential fracking investors reasonably worry that even though oil is very expensive now, the Saudis might yank the rug if American investment booms, crashing the price again.

I think that if not for climate sensibilities, progressives would clearly see that the thing to do here is set free-market dogma aside and try to minimize potential investors’ downside risk. Some of that is agreeing to refill the Strategic Petroleum Reserve at a deliberately high price per barrel to guarantee that the price won’t crash too much. The U.S. should also try to work with partner nations (especially Japan) that are net oil importers on extending that framework as broadly as possible. You might also want to consider loan guarantees or bailout promises. This sector is also experiencing supply-chain and labor bottlenecks, and the federal government should probably be actively working to funnel intermediate goods to it where possible.

This is objectively a fairly difficult problem, and nobody should pretend that Biden has a “pump more oil now” button on his desk that he’s just refusing to press. But I do think it’s reasonable to ask whether they fully appreciate how damaging energy scarcity is bound to be no matter what else happens in the macroeconomy. Energy prices rising faster than wages will be politically and substantively damaging even if overall inflation is right on target, and it calls for making every effort to increase production.

1

The Fed’s target is two percent inflation, but the index that they target, the Personal Consumption Expenditures Deflator, is calculated slightly differently from the Consumer Price Index in a way that makes 2 percent PCE inflation equal CPI inflation that’s a bit over 2 percent. But the CPI number is updated more frequently than the PCE number, so it’s more convenient to cite CPI data even though PCE data is more relevant. And, yes, this is a dumb and annoying problem that ideally the Fed and the Labor Department would sit down to work out.

2

If you don’t live in New England there’s a good chance you don’t even realize there are people still heating their homes with oil, but it’s common in that region. New England also gets really cold, so even though this isn’t a problem for most people, it’s a very serious problem in the part of the country where it’s an issue.

3

Thanks, rooftop solar!

Slow Boring

Expensive energy is really bad