Breaking the Boom-Bust Oil Cycle

Jason E. Bordoff and Gilbert E. Metcalf
Gilbert E. Metcalf, John DiBiaggio Professor of Citizenship and Public Service and Professor of Economics at Tufts University and Research Associate at the National Bureau of Economic Research
Gilbert E. Metcalf John DiBiaggio Professor of Citizenship and Public Service and Professor of Economics - Tufts University, Research Associate - National Bureau of Economic Research

January 6, 2009

Gas is cheap again, and that’s a mixed blessing. On the one hand, the drop in gas prices from their summer peak of more than $4 per gallon has put about $300 billion back in the pockets of U.S. consumers. But lower prices, projected to drop to $40 per barrel by the spring, also mean more driving and more oil consumption. That will, in turn, send more dollars overseas, bolster nations that are hostile to U.S. interests, and increase our economy’s vulnerability to oil price shocks. Not to mention that oil consumption contributes one-third of U.S. greenhouse-gas emissions each year.

Low oil prices also take the wind out of the sails of alternative-energy ventures, which would be unfortunate because, while oil prices are low right now, they won’t stay that way. Once we move past the current global recession, prices will shoot back up, thanks to the demand shock from rapid economic growth and supply constraints caused by underinvestment. Tighter supplies will also mean greater price volatility down the road.

Faced with this reality, policymakers need to take measures now, while prices are low, to encourage both conservation and development of alternative energy sources. But what are the options? A gasoline tax is a hard sell politically and ignores the 35 percent of oil consumed in the United States in forms other than gasoline. Moreover, a gas tax won’t directly reduce price volatility-it will only add to the pain of the next oil price spike. Others have proposed a price floor on oil, but that has an element of arbitrariness to it: There’s no reason consumers should enjoy all the benefits of market price declines until some random price point, and none of the benefits beyond that point.

As an alternative, we propose a variable oil security charge that’s phased in gradually over four years. The charge would rise when oil prices go down and decline when they go up. The precise formula could be negotiated, but we suggest a 40-40-40 approach: a charge of $40 per barrel (roughly $1/gallon at the pump) if the price of oil goes $40 per barrel or less, which declines by 40 cents for each dollar increase in the price of oil until the market price reaches $140 per barrel (just shy of last summer’s record price). After that, the charge would be zero.

A sliding security charge provides several benefits. Once it is phased in, the variable approach mitigates the economic pain of an oil security charge by rising only as oil prices go down. (Research into what economists call “loss aversion” shows that the pain of foregoing a dollar’s gain is significantly less than the pain of giving up a dollar.) A variable oil security charge would also act as an automatic stabilizer for the economy. Rising oil prices tend to slow economic growth, while falling prices act as a stimulant to the economy. Our oil security charge declines when prices rise and so acts as a fiscal stimulus to offset the negative impacts of oil price increases. And the oil security charge increases as oil prices fall, preventing the sharp increase in oil consumption that can contribute to an overheated economy.

A variable charge would also smooth oil price volatility and enable consumers and firms to better plan for the future. The Big Three automakers are suffering, in part, because they built profitable but fuel-inefficient cars when gas was cheap. When prices rose, demand for those cars plummeted. Automakers could develop products with greater confidence if they knew that gas prices wouldn’t fall so rapidly when oil prices plummet, as they have in the past few months. The oil security charge would also provide a strong, stable price signal to encourage both conservation and alternatives to oil. And reduced oil demand in the United States would lower prices worldwide—as a result, we estimate that 15 cents out of every dollar of the charge would actually be paid by oil producers through lower prices. In turn, reduced demand would mean fewer U.S. dollars sent overseas, and more revenue generated here at home. It’s just the policy we need to break the vicious cycle of oil boom and bust.