3580 pa628 1stclass - cato institute · 2016. 10. 20. · myths that have long distorted energy...

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Many politicians and pundits are panickedover the existing state of the oil and gasoline mar-kets. Disregarding past experience, these partiesadvocate massive intervention in those markets,which would only serve to repeat and extend pre-vious errors. These interventionists propose solu-tions to nonexistent problems.

This Policy Analysis reviews the academic liter-ature relevant to thesematters and argues that theprevailing policy proposals are premised on a mis-understanding of energy economics and marketrealities. The interventionists do not distinguishbetween problems that government can remedyand those that it cannot. They ignore lessons thatshould have been learned from past experience.They embrace at best second- and third-best reme-dies rather than first-best remedies for the allegedproblems. Moreover, they ignore the extreme dif-ficulty associated with ensuring efficient policyresponse even when it seems to be theoreticallywarranted.

Fear of oil imports is premised on perniciousmyths that have long distorted energy policy.The U.S. defense posture probably would not bealtered by reducing the extent to which oil is

imported from troublesome regions. Fears abouta near-term peak in global oil production areunwarranted, and government cannot help mar-kets to respond properly even if the alarm provedcorrect. Market actors will produce the capitalnecessary for needed investments; no “MarshallPlans” are necessary. Price signals will efficientlyorder consumer behavior; energy-consumptionmandates are therefore both unwise and unnec-essary. Finally, more caution is needed regardingthe case for public action to address globalwarming.

The omnipresent calls for more aggressiveenergy diplomacy are misguided. Economic theo-ry validated by historical experience implies thatthe diplomatic initiatives are exercises in futilitybecause they seek to divert countries from thewealth maximization that is their goal. Similarly,the search for favorable access to crude oil is futile.Despite their popularity, rules to force reductionsin energy use lack economic justification. Attackson American oil companies and speculators seekto shift blame to those subject toU.S. governmentcontrol from the uncontrollable foreign oil-pro-ducing governments that are truly to blame.

The Case against Government Interventionin Energy MarketsRevisited Once Againby Richard L. Gordon

_____________________________________________________________________________________________________

Richard L. Gordon is professor emeritus of mineral economics at the Pennsylvania State University. The issuesaddressed here have been his major research topics throughout and after his academic career. For further detail, seethe “Notes” section of this paper.

Executive Summary

No. 628 December 1, 2008

3580_PA628_1stClass:3580_PA628_1stClass 11/17/2008 8:06 AM

Introduction

The vast majority of both Republican andDemocratic politicians, including those in theGeorge W. Bush administration,1 are pushingfor increasedgovernmental interventioninener-gy markets. A disappointingly large number oforganizations that analyze policy issues havelikewise issued reports supporting such inter-vention.Withthepublicationofareport in2007titled Hard Truths: Facing the Hard Truths aboutEnergy: A Comprehensive View to 2030 of Global Oiland Natural Gas,2 the National PetroleumCouncil joined, among others, the NationalCommission on Energy Policy,3 the Council onForeign Relations,4 and the Milken Institute5 insupport of additional interventions in energymarkets.6 The source for the call—the oil indus-try itself—probably explains the attention theNPC report initially received.7 While there waslittle new in the report, its fuller-than-usual cov-erage ofmany of the issues that currently hauntpolicymakers, the attention ithas received fromthe trade press, and the fact that it came fromtheoil industry itselfmakes itaconvenientstart-ing point for a discussion about energymarketsand public policy.

AnOverview ofHard Truths and OtherEnergy Proposals

The standard 2008 case for energy interven-tion cites the dangers of oil-import dependenceand the related problem of high oil prices; theundesirability of oil use because of depletion,undesirable environmental impacts, or both;and the danger of globalwarmingdue to fossil-fuel consumption.This isoftenaggregated intoa call for energy independence, but energy inde-pendence is inconsistentwith oil-depletion andenvironmental-impact concerns. The NPCreport curiously rejects these standardpremisesbut devises similarly unsatisfactory alternativerationalizations for the samepolicymeasuresasother commentators advocate. The executivesummary of the NPC report argues that theUnited States must

• Moderate the growing demand for ener-

gy by increasing efficiency of transporta-tion, residential, commercial, and indus-trial uses.8

• Expand and diversify production fromclean coal, nuclear, biomass, other renew-ables, and unconventional oil and gas;moderate the decline of conventionaldomestic oil and gas production; and in-crease access for development of newresources.

• Integrate energy policy into trade, eco-nomic, environmental, security, and for-eign policies; strengthen global energytrade and investment; and broaden dia-logue with both producing and con-suming nations to improve global ener-gy security.

• Enhance science and engineering capa-bilities and create long-term opportuni-ties for research and development in allphases of the energy supply and de-mand system.

• Develop the legal and regulatory frame-work to enable carbon capture and se-questration. In addition, as policymakersconsider options to reduce CO2 [carbondioxide] emissions, provide an effectiveglobal framework for carbon manage-ment, including the establishment of atransparent, predictable, economy-widecost for CO2 emissions.9

The purpose of this Policy Analysis is todemonstrate that all but one of those proposi-tions—that pertaining to increased access togovernment-owned resources—are unsoundsuggestions typical of the prevailing energydebate. Those proposals allegedly derive fromthe “hard truths” that the NPC asserts aboutthe world energy market, which include chal-lenges to—but also acceptance of—the prevail-ing political rhetoric. The six hard truths high-lighted by the NPC report (which I havenumbered for convenience)10 are as follows:

1. Coal, oil, and natural gas will remainindispensable to meeting total project-ed energy demand growth.

2. The world is not running out of energy

2

The NationalPetroleum

Council joined,among others,the National

Commission onEnergy Policy,the Council on

Foreign Relations,and theMilken

Institute insupport ofadditional

interventions inenergy markets.


resources, but there are accumulatingrisks to the continued expansion of oiland natural gas production from theconventional sources which historicallyrelied upon. These risks create signifi-cant challenges to meeting the totalprojected energy demand.

3. To mitigate these risks, expansion of alleconomic energy sourceswill be required,including coal, nuclear, biomass, otherrenewables, and unconventional oil andnatural gas. Each of these sources facessignificant challenges, including safety,environmental, andpolitical or economichurdles, as well as imposing infrastruc-ture requirements for development anddelivery.

4. Energy independence shouldnot be con-fusedwith strengthening energy security.The concept of energy independence isnot realistic in the foreseeable future,whereas U.S. energy security can beenhanced by moderating demand, ex-panding and diversifying domestic ener-gy supplies, and strengthening globalenergy trade and investment. There canbe no U.S. energy security without glob-al energy security.

5. A majority of the U.S. energy sectorworkforce, including skilled scientistsand engineers, is eligible to retire withinthe next decade. The workforce must bereplenished and trained.

6. Policies aimed at curbing carbon dioxideemissions will alter the energy mix,increase energy-related costs, and requirereductions in demand growth.

There is a tension, however, between manyof these hard truths and the NPC policyresponses that follow from them. For instance,claim (1) is clearly valid, but it should suggestnonintervention, rather than the interventionproposed elsewhere in the report. Claim (2)substitutes for the standard dubious fear ofexhaustion the equally questionable fear of aworldwide failure to invest adequately in ener-gy production. Claim (3) similarly is premisedupon the odd idea that dominates the NPC

report thatmarket actors are unable to executeprofitable investments in energy. The first sen-tence-and-a-half of claim (4) is spot-on. Thelast sentence is a truism, and the text inbetween ranges from the banal to the indefen-sible. Clearly, energy imports require an in-crease in world trade and investment. Yet, nopublic policies are needed to produce the pos-tulated increases in trade and investment. Theclaim regarding domestic demand and supplypoints crosses the linebetweendescribingwhatmight happen in the marketplace and makingindefensible policy suggestions. Claim (5) is astatement of fact that has no satisfactory poli-cy implication. Claim (6) is tautological, andpresages the feebleness with which the reporthandles global warming.

Nevertheless, these truthsprovide thebasesfor the governmental intervention proposedby the NPC. This is an ironic outcome. Thereport, as the list of truths shows, dissentsfrom the import fears and resource pessimismthat is popular in other studies, but promotesnew and equally dubious problems that aremarshaled to justify the very same policy pro-posals that the other efforts advocate.

TheNPC’s case is developed in the first fivechapters of the report, dealing with, in turn,demand, supply, technology, geopolitics, andcarbon management (the report’s curiouseuphemism for global warming):

• The demand chapter moves from a pre-sentation of forecasts to a call for moreregulations to reduce energy use.

• The supply chapter is predominantly areview of forecasts and resource-avail-ability studies into which concernsabout the difficulties of ensuring neces-sary investment are interwoven.

• The technology chapter ranges over avariety of options, with the bulk of theattention given to conventional andunconventional sources of oil and gas.Stuck at the beginning is an examinationof thedangers of an inadequate supply ofpeople who are trained to manage energyventures.11

• The geopolitics chapter has little sub-

3

There is atension betweenmany of thesehard truths andthe NPC policyresponses thatfollow fromthem.


stance; it does not distinguish among thethreats that prior writers have seen as rel-evant to policy; those that are unfortu-nate, but towhichmarket economies canadapt; and flights of fancy about oil-access wars. The NPC displays a faith innegotiation as a remedy, which makes noeconomic sense, and has proved worth-less in practice.

• The carbon management chapter is soperfunctory as to have been better omit-ted.

The NPC report does not merely embracethe principle of intervention; it advocates con-tinuation and even extension of the many ill-advised energy policies that survived the par-tial deregulations of the 1981–1992 Reagan-Bush administrations.

The recommendations start by proposing atightening of energy-performance standards,first in motor vehicles and then in the residen-tial andcommercial sectors.TheNPCalso callsfor related increases in government researchand development, and federal demonstrationprojects to highlight better industrial energy-use techniques.

More critically, later recommendations buyinto the pernicious fallacy that oil is a specialcommoditywhoseavailability isheavilyaffectedby political considerations. Without any sup-porting evidence, the NPC transforms the pos-sibility of politicization into a near certainty:

The world is entering a period in whichinternational energy development andtrade are likely to be influencedmore bygeopolitical considerations and less bythe free play of open markets and tradi-tional commercial interactions amonginternational energy companies.12

Consequently, the NPC believes that ener-gy should become a central focus of policy inevery relevant diplomatic realm. The reportcalls for the United States government to13

• Integrate energy policy into trade, eco-nomic, environmental, security, and for-

eign policies by having the Departmentof Energy share an equal role with theDepartments of Defense, State, Treasury,and Commerce on policy issues relatingto energy and energy security.

• Continue to develop the internationalenergymarketplaceby expanding the ener-gy dialogue with major consuming andproducingnations, includingChina, India,Canada,Mexico, Russia, and Saudi Arabia.

• Promote an effective global energy mar-ketplace by sustaining and intensifyingefforts to encourage global adoption oftransparent, market-based approachesto energy through multilateral andinternational institutions—includingthe World Trade Organization, G8, theAsia-Pacific Economic Cooperation, theInternational Energy Agency, the Inter-national Energy Forum, and the JointOil Data Initiative.

• Assist and encourage global adoption ofenergy transfer programs and lend-leasearrangements.

The critical element of the report’s over-reach is the NPC’s call to subsidize virtuallyevery energy resource imaginable: enhancedoil recovery, conventional oil and gas, oilshale and oil sands, unconventional naturalgas, biomass, coal, and nuclear (solar powerand wind power are praised elsewhere in thereport).14 A mishmash of policies is suggest-ed to promote those energies. While the NPCnods toward the need for better federal landsmanagement policy to facilitate the produc-tion of energy (with particular attention giv-en to oil shale, oil sands, and unconventionalnatural gas), a report stressing more reason-able regulation would have been much morehelpful than what appeared.

On the positive side, the report offers alaudable, but familiar, laundry list of desir-able attributes for the world energy market.15

Those attributes include

• a competitive market• stable and diverse supply with minimal

disruptions

4

The criticalelement of the

report’s overreachis the NPC’s call

to subsidizevirtually everyenergy resource

imaginable.


• low price volatility• adequate spare capacity and logistical

infrastructure• diverse energy mixes• protection of the global environment,

including climate considerations• flexibility to accommodate shifting

demand patterns• transparency and reliability of commer-

cial relationships

The NPC concludes that neglecting theseobjectives in a blind pursuit of energy self-sufficiency would risk unintended andharm-ful consequences for both energy suppliersand consumers alike.16 The authors, however,adopt undesirable proposals to support thesegoals. In particular, the NPC seems to believethat the United States has the ability to con-vince the world to embrace this vision forworld energymarkets, and the ability to assistin an attempt to translate that wish into real-ity.

Common Pitfalls of “Blue Ribbon”Reports

Unfortunately, the NPC report shares sev-eral key defects with other recent and earlierreports, studies, and books that have plowedthis policy terrain.17 The NPC study is simplyone of a long line of ostensibly “blue-ribbon”reports that say more or less the same thingand argue more or less from the same foun-dation. None constitute a serious attempt todeal with energy issues.

The errors found in these reports are theinevitable result of the politics of blue-ribbonpanels. They are designed to include a widevariety of views, make quick decisions, andare at the mercy of a supporting staff whosequalifications depend upon the decisions ofthe study’s administrators. As subsequentmaterial should suggest, the competence ofsupport staff is widely variable. Moreover, thepressure to rapidly reach a consensus andunite behind it often produces the bloatedset of proposals criticized here.18

A particularly unfortunate aspect of theNPC report is that it fails to even provide

what is advertised—the industry’s perspectiveon the issues at hand. While the NPC wasonce the source of insights from industryexperience, its aggressive use of non-industryanalyses and arguments add external viewsthat lead to incoherence.

That aside, the primary problem manifestin the energy reports noted here is theirappalling failure to acknowledge the implica-tions of past experience. There is nothingnew, for instance, about producer instability,the search for reliable sources of energy, orthe need for finance and staff for energyexpansion projects. More critically, the his-torical record shows the inability of govern-ment to effectively assist industry in meetingthose challenges.

During the energy turmoil of the 1970s,economists engaged in a great effort to critical-ly examine the then-prevailing energyproblemsand the policies adopted as reactions to thoseproblems. The basic conclusion was that novalid economic defenses existed for the inter-ventions thatwere adopted. Somecontroversialarguments were made for alternative interven-tions, but theyhavenot stoodup.Nothing thathas occurred since then has altered these con-clusions. Unfortunately, too many commenta-tors have forgotten previous work on theseissues.

TheNPC report—like the other studies andreports mentioned above—also pays too littleattention to the underlying economics ofenergy. While a report to a general audiencemaydownplayorpopularize the technical eco-nomic issues, the implicit failure to recognizethe issues in play is unacceptable. At times, theNPC, unlike other studies, does state—albeitwithout elaboration—purported economicrationales for its proposals. None of those jus-tifications, however, are persuasive.19 Thatshould not surprise: the passion to act regu-larly inspires neglect of those economic princi-ples that undermine the case. Regardless, whatwas intended as a fresh look at energy issuesrepeats chronic errors.

TheNPC report, likemost others, errs dou-bly by advocating inferior, and, in the criticalinternational-oil case, totally ineffective cor-

5

The primaryproblemmanifestin these energyreports is theirappalling failureto acknowledgethe implicationsof pastexperience.


rective measures of a type identical to thoseproposed in the Cheney report. Thus, evenwere the problems real, the proffered policyagenda would not correct them.

The Underlying Economics of EnergyThe discussion that follows offers a sum-

mary of the underlying economics literatureon energy markets and governmental inter-vention in the same and contrasts those find-ings with the main arguments offered in theenergy agendas advocated by the most popu-lar public reports.

First, I deal with the economics of oil-im-port dependence, the main concern of most ofthese blue ribbon reports. The oil-dependencedanger is the subject of an extensive, but spe-cialized, literature. Both economic theory andactual experience suggest that the present hys-teria is unwarranted.

Next, I turn to the alleged shortcomingsof capitalmarkets, which is the only plausibleeconomic basis for public policy to addressenergy depletion. These concerns have right-ly become a backwater of economic analysis;economists have abandoned their concernsover the issue.

Following that, I address the environmen-tal impact of energy consumption, a well-established interest of modern economists. Aswith all environmental issues, however, eco-nomicsonly can suggestwhat todo, given thatthe impacts from man-made global warmingare conclusively established to exist and proveharmful.

Then, I consider the implications of imper-fect information in energy markets andwhether intervention to reduce energy con-sumption is warranted by the same. Marketsareperfectly capableofdealingwithmost ifnotall information-related problems in both theo-ry and practice.

Next, I briefly discuss the current obses-sion with speculators and the impact of mar-ketmanipulationon energy prices.While thisissue has been neglected in the blue-ribbonreports discussed in this paper, it reappearsregularly in energy policy debates and is amanifestation of economic illiteracy.

After that, I consider the importance ofselecting the appropriate remedies for identi-fiedproblems.Theallegedproblemshighlight-ed by the NPC can be better and more directlyaddressed by straightforward interventionsthat were never considered by the NPC andsimilar studies. This is another example of theunanalytic, ahistorical devotion to pet reme-dies that mars current energy policy discus-sions. These errors are another consequence ofarguing without considering the relevant eco-nomics. Rather than first-best responses, theNPC report embraces (at best) third- or fourth-best responses that will fall short of their poli-cy mission, introduce unintended conse-quences that complicate markets even further,or do both.

Finally, I examine the difficulty involved inremedying market failures with governmentintervention, even when those market failuresclearly exist. The NPC report, like almost allother such reports, is quick to argue that mar-kets fail on a wide range of fronts, yet implicit-ly assumes that government remedies to mar-ket failures never misfire. A vast literatureproves exactly the opposite.

Oil Import Problems inthe Economics LiteratureStarting well before the oil turmoil of the

1970s, economists have found oil to be amajor area for study. An enormous literatureexists, and more accumulates on a regularbasis. The material ranges over many issuesand cannot be fully reported or reviewed here.

The single most critical contribution hasbeen that of ProfessorM. A. Adelman ofMIT.Starting in the 1960s, he undertook a com-prehensive examination of the underlyingeconomics of world oil and how it was affect-ed by public policies around the world. Hisclassic synthesis book reached completionjust as the oil turmoil broke.20 Two decadeslater, he critically chronicled the evolution ofoil markets from 1970 through the after-math of the first Gulf War, with a particularfocus on the behavior of oil-exporting coun-

6

Both economictheory and actual

experiencesuggest that the

present hysteria isunwarranted.


tries.21 Adelman was by no means the onlyeconomist to explore this terrain—and manycontinue to work in these vineyards at pre-sent—but his contributions have proven themost important.

An interesting parallel to Adelman’s workwas produced by President Nixon’s CabinetTask Force on Oil Import Control.22 This wasone of those rare government studies that seri-ously examined the issues. The effort receivedfirst-rate staffing, and sought and receivedexcellent input on the issues. Several leadingenergyeconomistsprovidedconsultingreports,and interested parties were invited to provideinput. The result was an impressive review ofthe issues, focusing on the centrality of foster-ing and preserving competition in oil and theunsuitability of the then-existing import quotasystem for oil. Unfortunately, the advice wasignored.

Numerous reviews of import dangers andpolicy have since emerged with importantcontributions by economists at Resources forthe Future, such as Milton Russell, DouglasBohi, Michael Toman,23 and, most recently,Ian Parry.24 The fascination with governmentoil stockpiles produced several efforts.25 Themacroeconomic implications of oil-supplyshocks have also received a great deal of atten-tion. Professor James Hamilton at the Uni-versity of California, San Diego, is the mostquoted advocate of the argument that oilshocks cause major macroeconomic disloca-tions, but, as sketched below, many have con-curred or dissented.26 The most comprehen-sive synthesis of oil economics and publicpolicy, however, was produced by energyeconomist Robert L. Bradley Jr.27

Economics vs. Politics inWorld CrudeOil Markets

A long-standing conflict prevails betweenthose who believe that the world oil supply isprimarily driven by the conventional eco-nomic objective of wealth maximization, andthosewhobelieve that political influences aredominant. Neither view, however, should bepushed to its logical limits.

Proponents of the economic view generally

recognize that at least one important depar-ture fromwealthmaximization has arisen: thenationalization of the oil industry withinOPEC countries during the 1970s. The abilityof national oil companies to hire foreign man-agers, combined with prior efforts by OPECmembers to arrange that its domestic work-force secured training in petroleum industrymanagement, ensured that operations werenot undermined. Investment decisionmaking,on the other hand, was harmfully altered.During the private-ownership oil regime, for-eign contractors concentrated on makingprofitable investments in capacity mainte-nance and addition. With nationalization,however, the funds derived from oil produc-tion became part of a national pool of wealth,and oil investments had to compete with oth-er governmental priorities. The effects of thison the industry illustrate the fallacy of relianceon allegedly superior governmental invest-ment skills (an issue to which I return later).28

One clear consequence of an economics-based view of oil is that if oil policy is governedby national self-interest, the engagement withproducers—so beloved among politicians andtheNPC—isatbest awasteof time, andatworstan arrogant presumption of superior knowl-edge. Exporting, if profitable, will be undertak-en whatever foreign diplomats may suggest.Conversely, unprofitability precludes exports.29

Akeypointhere is that, todate, thedanger fromimports has been of temporary disruption ofsupplies due to some local crisis.30 This is amanageable problem that free-market institu-tions could have handled if they had not beenthwarted by intervention (another matter towhich I will return later). Eliminating or evensharply reducing oil imports is not a sensibleresponse to such short-term disruptions.

It is premature to postulate and respond tothe risk of longer-term supply disruptions.Indeed, it is hard to conceive of plausible long-term threats. The advantages of oil trade tobuyers and sellers are powerful incentives forboth to maintain flows. Oil is more easilyextracted, transported, transformed, and uti-lized than any other fuel. Rival energy sourcesare so costly that they prevent the energy tran-

7

The advantages ofoil trade to buyersand sellers arepowerfulincentives forboth tomaintainflows.


sitions so eagerly advocated by many com-mentators. The resulting revenues to produc-ing countries dwarf what they can earn else-where.

A classic illustration was Richard Nixon’scall for energy independence. Fortunately, theold Federal Energy Administration assembleda team of bright young operations researchersto synthesize the numerous studies commis-sioned to support the Project Independenceinitiative. Their well-designed (but necessarilyvery oversimplified) model nicely quantifiedwhat experienced energy observers sensed: thenature of petroleum use with its heavy con-centration in the transportation sector makessubstitution extremely expensive.31

Conversely, the political theory of produc-er behavior bears a strong resemblance towhat economists call the “managerial-slackmodel” of firm behavior. In that model, pro-ducers supposedly have sufficiently limitedobjectives, so that they sacrifice opportuni-ties for wealth maximization. The politicaltheory of producer behavior, however, hasthe same inherent implausibility as the slacktheories that it resembles.32

More critically, the key example cited tobuttress the argument that politics drives pro-ducerbehavior—thepurportedAraboil embar-go of 1973—implies no such thing. First, therewasnoembargobecause selective embargosareinfeasible.33 Once oil hits the high sea, its desti-nation cannot be controlled. Moreover, anembargoednation can easily shift toother sup-pliers. Adelman’s classic 1995 analysis of worldoil argues thatwhateverproductionreductionsthat were undertaken were motivated by adesire to force up oil prices rather than by adesire to punish anyone for support of Israel.

Further evidence is provided by the effectsof the critical revolutions in Iraq, Libya, andIran, in which rulers who were friendly to theWest were replaced by rulers who were hostileto the West. Aside from the later years ofSaddam Hussein’s rule in Iraq, those hostilerulers were at least as dedicated as their prede-cessors to the maintenance of oil supplies.34

Even Saddam Hussein’s attacks on Iran in1979, and Kuwait in 1991, had wealth-maxi-

mizing aspects. To be sure, the moves weremotivated by ancient enmities. However, theefforts could also be construed as oil grabsbased on ill-conceived beliefs that more oilwealth could be secured cheaply.

Similarly, Adelman’s 1995 book convinc-ingly demonstrates that the special relationwith Saudi Arabia is a sham. Saudi Arabia, asshould be expected, does what is in its eco-nomic interest, which rarely means doingwhat the United States wants.35 No vision ofoil-exporter restraint from wealth maximiza-tion implies either that good relations areneeded to ensure supply or that the exportersare susceptible to cajoling.

The nadir of this stress on diplomacy wasthe notorious 1971 Tehran negotiations.36 Aswas ultimately learned by reporters fromForbes, the State Department, apparentlyunder the leadership of its long-time energyadvisor James Akins, pushed through a pro-ducer-consumer deal that allowed majorincreases in oil prices, ostensibly as a means ofheading off even larger price increases. Adel-man argued that the government’s timiditywould unleash even more vigorous efforts toraise oil prices closer to a monopoly-profit-maximizing level. The 1973-74 oil price spiralwas the realization of Adelman’s warnings.37

As Adelman also warned, what has beencritical is the oil dependence of these coun-tries. Most possess nothing else that can pro-duce significant incomes.Others have becomeso dependent on oil that other industries liefallow. Maximizing wealth and spending theproceeds is far more rewarding to producerstates than the capricious political manipula-tion of markets.

Some have suggested, at least tacitly, thatthe rise of Islamic fundamentalism profound-ly alters the situation.That suggestion rests onat least two critical implicit assumptions: first,that because fundamentalists are willing toharm fellow Muslims, radical fundamentalistgovernments would take the ultimate step—avoided by the Iranian fundamentalists—ofdooming Islamic nations by ceasing oil pro-duction; and second, that these fundamental-ists have good prospects to assume power in

8

Once oil hitsthe high seas,its destination

cannot becontrolled.


many oil-producing states. A possible thirdtacit assumption is that the strategy of eco-nomic suicide could not be resisted any morethan a scorpion could resist stinging theproverbial frog that was carrying it across thewater.While all thismight occur, it appears fartoo wild a possibility to be the core of nation-al energy policies. Moreover, it is unlikely thatany good strategy exists to prepare for thisdoomsday.

The belief that oil producers are motivatedby political considerations breeds the beliefthat some set of policies can ensure favorableaccess to oil relative to other customers. Ofcourse, in markets governed by economicprinciples, access is secured by paying the pre-vailing market price, regardless of how com-petitive the market may be. With textbook-pure competition, everyone is a price taker,buying or selling what is economic at the pre-vailing market price. With imperfect competi-tion, some sellers and buyers may affect theprice, but sellers will still sell to all at whateverprice results from the interaction.38

Logic and experience suggests that thesearch for favorable access is an exercise infutility. All parties in the oil trade face enor-mous pressures not to indulge in favoritism.By definition, favoritism is bad for the pro-ducing companies and countries. Favoritismcan only mean selling to less remunerativeoutlets. Even the consuming countries sufferthe consequences of diversion from whatmay be actual or potential allies.

Reality, however, has not prevented pursuitof special relations with oil producers. Theclassic illustration was the maneuvering tosecure rights to develop oil in the Middle East.The first important case was the British gov-ernment’s purchase of the company that wasdeveloping Iranian oil resources (the predeces-sor of today’s BP).39 The key symbolic start ofthe United States’ embrace of the political-relations approach to oil was Franklin D.Roosevelt’s 1945 visit with Saudi Arabian kingIbn Saud. Other forms of deals have arisen.France and Japan have likewise engaged infutile efforts to establish special relations withoil producers. Current Chinese efforts simply

repeat past errors and are thus of nogreat con-cern. No evidence exists that these arrange-ments have ever affected product allocations.

The NPC raises an alternative, more ger-mane worry regarding access: the willingnessof governments to allow the development ofoil and gas resources. A good example of thisproblem is the reluctance of the UnitedStates government to lease oil-developmentrights on federal land and in coastal waters.This is surely the best policy analysis in theNPC report. It gets lost, however, in the bar-rage of mostly questionable suggestions else-where in the report, particularly the move toinfer similar reluctance in the rest of theworld.

In sum, the economic view of oil advocatedhere holds for the primacy of economic goals,recognizes that oil markets generate vast rev-enues that may be and indeed often are mis-used, and acknowledges that the feasibleoptions open to the United States and othermajor oil consumers are limited to avoidingincentives to rig markets. Given that oil-mar-ket behavior is determined by the exportingcountries’ perception of what the market willpermit, it is fantasy to believe that oil-import-ing countries can redirect the policies of oil-exporting countries. Countries cannot be per-suaded to ignore their economic interests. It isequally unrealistic to believe that dialogue willimprove these countries’ knowledge ofmarketrealities. If anything, their record in marketperception far excels that of consuming-coun-try governments. That should not be a sur-prise. Exporting-country survival depends onrealism about markets. Consuming-countrygovernments, in contrast, are essentially by-standers to decisions made by their citizens.These governments thus face little or no pres-sure to be correct.

A related form of wishful thinking is thatconsuming-country governments can per-suade oil-exporting countries to eliminate themany undesirable ways in which oil money isused. These misuses are broad and real. Theyinclude corruption, support of destabilizingactivities in other countries, and overinvest-ment in armaments. Given the strong forces

9

It is fantasy tobelieve thatoil-importingcountries canredirect thepolicies ofoil-exportingcountries.


that lead to such excesses, it is futile to expectthat external criticism will have any impact.

Import Dangers RevisitedBefore dealing with specific issues related

to oil imports, various views on the subjectrequire our attention. Among the studiescriticized here, the 2006 Council on ForeignRelations Task Force has the clearest andfullest listing of the problems widely believedto be associated with excessive reliance onforeign oil. The task force saw six dangers:

1. “The control over enormous oil rev-enues gives exporting countries theflexibility to adopt policies that opposeU.S. interests and values.” (p. 26)

2. “Oil dependence causes political realign-ments that constrain the ability of theUnited States to form partnerships toachieve common objectives.” (p. 26)

3. “High prices and seemingly scarce sup-plies create fears—especially evident inBeijing and New Delhi, as well as in Euro-pean capitals and in Washington—thatthe current system of open markets isunable to ensure a secure supply.” (p. 27)

4. “Revenues from oil and gas exports canundermine local governance.” (p. 28)

5. “A significant interruption in oil supplywill have adverse political and economicconsequences in theUnitedStates and inother importing countries.” (p. 29)

6. “Some observers see a direct relation-ship between the dependence of theUnited States on oil, especially from thePersian Gulf, and the size of the U.S.defense budget.” (p. 29)

This list is characteristically problematic inits failure to distinguish between what is dis-turbing but uncorrectable and that to which asensible response is possible. Danger (1) is amuch-repeated irrelevance. As noted earlier,there is nothing the United States can do toaffect the situation. At best, any strategies thatlower oil priceswill lessen thepower todomis-chief.Danger (2) expresses anold concern thatothers will be more unwise than the United

States in seeing and trying to counteract polit-ical forces in oil markets. Danger (3) then pos-tulates an unfamiliar proposition that othersalsowill bemore errant in perceivingwhat dri-ves the market. Danger (4) is another exampleof the untenable belief that the quality of for-eign governments matters to and is cor-rectable by, the United States. Danger (5)ignores the fact that supply disruptionswouldhave the same effect on a nation regardless ofhow much oil it imports. Danger (6) is astrange, unhelpful twist on an old argument.Instead of deploring security costs, we worrythat others fear the existence of these securitycosts. Adirect considerationof security costs ispreferable.

In contrast, Bohi and Toman’s much morecritical survey of the economics of oil importsidentifies three relevant policy issues: thepotentially reducible effects of higher oilprices, the macroeconomic effects, and theeffects on the military budget.40 A discussionof each follows below.

World Oil Prices and U.S. PolicyIn the early 1970s, both Professor Adelman

and the Cabinet Task Force on Oil ImportControl concluded that the main concern oftheUnitedStateswhen it comes tooilmarketsis to ensure that there is vigorous competitionin those markets. This was precisely what wasnot being done at the time. The United Stateshad for years protected the domestic oil-pro-ducing industry by imposing quotas on oilimports.41 Denied theopportunity to competefor sales in U.S. markets, exporters turned tomarket-rigging operations.

The infamous oil negotiations in 1971,first with Libya and then in Tehran with theMiddle Eastern producers, were the greatturning point. Adelman’s initial view wasthat the negotiations produced price-riggingpolicies that would have been avoided hadexporter demands been resisted, but he laternoted that perhaps the outcome would havearisen in any case. In any event, the federalgovernment’s ambivalence about competi-tion in oil markets made the creation of a car-tel easier.

10

The main concernof the UnitedStates when itcomes to oilmarkets is to

ensure that thereis vigorous

competition inthose markets.


Since 1971, the oil-exporting countrieshave secured sharply higher but volatile prices.Some analysts argued, particularly in the earlyyearsofhighprices, that thosehighpriceswereless the product of production constraint bythe cartel than they were the product ofendogenous shifts in global supply anddemand that would have occurred whetherthe cartel existed or not.42 Subsequent experi-ence, however, indicates that the cartel has, infact, had a hand in those price fluctuations. Inparticular, market behavior involved price col-lapses and spikes without major changes inthe underlying demand or supply. Adelmannicely epitomized the situation as one of aclumsy cartel.43

The reason that the cartel exhibits “clum-siness” is because OPEC member states oftendisagree about cartel strategy, exhibit an on-again, off-again commitment to agreed-uponproduction quotas, and lack conclusiveinformation about how far they can push themarket on price at any given time. Thus,prices have cycled widely and wildly. The cur-rent worldwide oil price boom, for instance,followed years of historically low prices.

Several ideas have been forwarded to coun-teract the power of the OPEC cartel, but theonly credible idea that has arisen is an oil-import-quota auction.That idea,whichgainedsome academic traction in the 1970s, has itsroots in the venerable international trade theo-ry concept of an optimal tariff. The case for anoil-import-quota auction follows from the factthat large consuming nations collectively havemonopsony (buyers’ monopoly) power. Theo-retically, one could impose a tariff that restrictsimports and lowers prices receivedby exportersto their monopsony-optimum level, or elsethat optimum-import level could be set as aquota.

Several problems arise, however, in imple-menting such an optimum tariff or quota.First, determining the proper import level isbeyond the capabilities of any governmentanywhere. Second, protectionist instincts maylead to excessively high restrictions. Third,exporters might retaliate and trigger a world-wide trade war. Fourth, a great power seeking

to foster international trade sets a very badexample by engaging in opportunistic restric-tions. The United States has undertaken toomany unjustified interventions, such as insteel and automobiles; piling on more is notdesirable.

The quota auction variant of this idea wasproposed largely to exploit a weakness inher-ent in all cartels. The fundamental insighthere is that if cheating on cartel productionquotas can be concealed, cartel members willbe more willing to cheat. Hence, auctions forexport rights to consuming nations would bein the form of sealed bids with the resultskept secret. Unfortunately, it is doubtful thatthe secrets in question could be kept.

The many and varied problems associatedwith and an oil-import-quota auction havelargely (and rightly) killed interest in the idea.The clearest advice for consuming states thatremains unscathed is that they do nothing toobstruct the flow of oil in world markets. TheNPC recognizes, but does not analyze, what isalways at the core of world oil issues—the com-petitiveness of themarket. TheNPC’s stress ondiplomatic approaches, as noted, is an unreal-istic response to the challenge of stimulatingcompetition. What is really needed is to donothing to create fears ofmarket-access restric-tion. In short, the biggest danger of imports isthe hysteria about them and the market-dis-rupting measures proposed as cures.

TheMacroeconomics of OilAnother hearty perennial is that oil-price

instability, supposedly exaggerated by depen-dence on oil imports, has severe adversemacro-economiceffects. Inparticular, it is said tocausethe simultaneous appearance of inflation andunemployment. As sketched below, academicshave conducted extensive investigations of thismatter, and a wide range of views has arisen.Unfortunately, formidable econometric prob-lems arise in separating out the impacts of oil-price increases from those of other factors, par-ticularly monetary policy. The most recentwork, nevertheless, seems skeptical about theargument that major macroeconomic impactsfollow from oil-price volatility.

11

OPECmemberstates oftenlack conclusiveinformationabout how farthey can push themarket.


Any discussion of this issue must beanchored in the revolution inmacroeconomicsthat occurred in the 1970s and initiated thethird phase of the evolution of macroeconom-ics.44 Prior to the appearance of John MaynardKeynes’s General Theory in 1936, economicinstability was treated in a fragmentary, unsys-tematic basis. Keynes provided the basis for amore systematic framework.45 His own formu-lation was very loose, but several commenta-tors, particularly J. R. Hicks, prepared formal-ization that transformedKeynes’ ideas into theKeynesian model of macroeconomics.46

The second evolution was the rise of themonetarist school of macroeconomics, mostnotably advanced by Milton Friedman, KarlBrunner, and Allan H. Meltzer. Friedman, incollaboration with Anna Schwartz, produceda massive history of U.S. monetary policy thatargued that it was inept monetary policyrather than some breakdown of the capitalistsystem that had caused economic instability,particularly the great depression of 1929–33.47

Monetarists argued that monetary policy wasmore influential than fiscal policy in deter-mining the course of macroeconomic events,which directly contravened much of theKeynesian perspective. This contention hadenormous influence with many leading econ-omists who accepted the findings.

The third evolution of macroeconomicthought was ushered in by a group of youngereconomists led by Robert Lucas,48 ThomasSargent, and Neil Wallace.49 They incorporat-edprinciples fromtraditional economics, suchas good foresight and rapid market clearinginto macroeconomic thought. Taken to itsouter limits, this “rational expectations” ap-proach implies that economic instability willnot arise, and, if it did, intervention to reverseinstability would not work. While these theo-ries are heavily criticized for assuming farmoreknowledge that actually exists, that is thepoint. Economic instability is no longer inher-ent, but comes from precisely what economictheory cannot handle: unanticipated changesin public policy.

All this matters to theories of oil-priceshocks and economic instability because the

newer theories aremuch less supportive of theidea that oil-price instability can inducemacroeconomic shocks. Economists BenBernanke, Mark Gertler, and Mark Watson,for instance, conducted an econometricanalysis and found that the macroeconomicimpact of oil-price shocks has historicallybeen caused by improper monetary responsesto the shock and that a more stable monetarypolicy couldhave avoided the harms.50 RobertBarsky and Lutz Kilian likewise found thatbad monetary policy, rather than oil shocks,caused the stagflation of the 1970s.51

In sum, while the debate has not been set-tled, concerns about oil shocks have beengreatly lessened. The literature on oil shocksreveals that formidable problems exist, inboth establishing a convincing theoreticalanalysis regarding why macroeconomic im-pacts arise, and then econometrically testingthe subsequent theories. The weak theoreticalsupport for the fear that oil-price shocks cantrigger significant macroeconomic deteriora-tion, combined with the formidable difficul-ties in isolating the effect of oil-price shockson the economy as a whole, inspires skepti-cism about oil-shock theories. Certainly, thetheories do not support reducing imports inthe hope that the shocks will be sufficientlyless profound in order to justify the large,clearly extant costs associated with importrestrictions.

At present, the main U.S. policy foraddressing the macroeconomic risk of oil-price shocks is the Strategic PetroleumReserve, a public inventory of crude oil thatwould theoretically be available during suchshocks. Thus, doubts about the dangers asso-ciated with those shocks weaken the case forthe Strategic Petroleum Reserve. An alterna-tive explanation for the alleged suboptimallevel of private oil inventories is that the regu-lar imposition of price controls discouragesoptimal inventory levels and that a publicstockpile can compensate for this.52 The previ-ously cited literature on stockpiling, however,suggests that considerable problems exist inensuring optimal release of public inventories.This led me to conclude that the fundamental

12

The literaturereveals

formidableproblems inestablishing aconvincingtheoreticalanalysis

regarding whymacroeconomicimpacts arise.


problemwaspolitical fear ofwindfall profits.53

As Taylor and Van Doren observed, this is afundamental defect for which no credible cor-rective action exists.54 Every indication is thatthe error of controlling prices will be repeated.Thus, the stockpile has no satisfactory justifi-cation.

Investment Myopia andthe End of Oil:

The Theory and Practice ofEnergy Transition

People who are alarmed about trends inenergy markets commonly contend that adecline of oil production is impending, yet pri-vate investors are not correctly anticipatingthis development. These assertions inevitablylink back to M. King Hubbert’s inadvertentlyprescient prediction of a decline in U.S. oilproduction. Hubbert’s analysis, however, wasbased on a statistical appraisal of the physicalavailability of oil in the United States, not inthe world as a whole.

In practice, economic limits to productionkick inwell before geological limits, and that iswhat happened in the United States. Oil pro-duction declined, not because of depletion,but because a superior (less-costly) alterna-tive—Middle Eastern oil—arose. The peak wasreached later thanwas desirable because of thefederal government’s policy of restricting oilimports. Thus, it was dumb luck that the pat-tern of decline dictated by changing energypolicymatchedwhatHubbert expected due tophysical limits.

The imperfect-foresight argument, in gen-eral, is an absurdity. To believe that govern-ments are better anticipators of the futurethan private investors ignores the vast recorddemonstrating the contrary.55 This is particu-larly true of the extreme pro-governmentclaims discussed further below. These viewsposit a government dispassion and wisdomthat is lacking in the private sector. Experienceshows the opposite. The private sector has theadvantage of a multiplicity of actors whose

survival depends on correct decisions. In theo-ry, things might be so unpredictable that dis-astermight arise fromsudden changes thatnoone could foresee. This is unlikely in energy.The participants are always concerned about,and act to anticipate, future developments.The large size and profitability of oil compa-nies reflects their skills at appraising pros-pects. If the companies fail, no one else will dobetter.

An alternative view employs an often usedbut wildly implausible concept of market fail-ure–thebelief thatmarket actorswill not estab-lishenoughprocedures tohedge risksandthuswill produce inefficiently low levels of invest-ment. Ronald Coase’s point (see below) aboutthe costs associated with transactions such ashedging is the critical analytic response to thecriticism.56 Every possible risk is not hedgedsimply because most of them are too small tojustify establishing protective measures.

The facts are even more devastating. Theyears since World War II have seen the rise ofa vast array of new financial instruments.Mutual-fund companies have introduced astunning variety of options that differ in theextent of their active management, whetherstocks, bonds, or other assets are involved,what countries are included; in what sectorsof the economy investments are made; and inwhich markets the shares are purchased.Futures markets emerged for crude oil whenthe major oil companies lost their oil conces-sions from OPEC nations.

Moreover, improving foresight does notnecessarily translate into reducing oil produc-tion, let alone support the conclusion thatpeak oil is near. To discuss this issue intelli-gently, a review of the underlying and exten-sive literature on exhaustible-resource man-agement is necessary.

The first widely cited item in the literatureis an article by L. C. Grey in 1914.57 Sub-sequent writers made Harold Hotelling’s 1931article on the subject the iconic starting pointof the literature.58 In the 1960s, however, nat-ural-resource economists such as AnthonyScott,59 Orris Herfindahl,60 Richard Gordon,61

and particularly Ronald Cummings,62 made

13

To believe thatgovernmentsare betteranticipators ofthe future thanprivate investorsignores thevast recorddemonstratingthe contrary.


the critical contributions that produced theessence of this theory.63

Hotelling’s theory explains the optimalbehavior of a producer who is producing agood in which supply is fixed by nature. If thedemand for that good persists long enough sothat it is profitable to hoard output, then it isno longer optimal to sell at a price equal to themarginal cost of production. Instead—becausethere would be later periods in which, becauseof depletion, no demands could be met—opti-mally restricting the earlier output to meetthese later demands would be profitable. As afew expositions of the theory have noted,should that critical timeofunsatisfieddemandbe nonexistent or simply at a sufficiently dis-tant date, efficient current behavior wouldignore the eventual depletion.64

When depletion comes nearer, wealth-max-imizing resource owners would respond byrestricting output to provide for later genera-tions.However, contrary tomany or evenmosttreatments of Hotelling, this would not pro-duce a simple, readily observable impact onprices.65 When dealing with homogenous re-sources producible at constant costs,Hotellingargued that the “net price” (the average profitper unit of output) would rise at the marketrate of interest.66 With pure competition inmineral rights, those rents would be paid asroyalties. However, because production incurscosts, the market price would necessarily growat a slower rate than profits.

Other work found that resource hoardingcan produce two further economic rewards.First, Grey’s pioneering effort stressed thatwith the standard assumption of increasingmarginal costs, output reductions raised prof-its by lowering marginal costs. Extensions ofHotelling’s general case showed that a furtherrewardarises if resources areheterogeneous. Inthat case, reducing output delays the increas-ing costs of cumulative production. Severalwriters demonstrated that the benefit of delay-ing thedepletionof “better” resourceswas sim-ply the sum of the present values of the result-ing cost savings. While this is an unsurprisingresult, much effort went into its derivation.67

While this analysis usually implies rising

prices and falling output over time, those out-comesarenot inevitable.Rapidbutdeceleratingshifts in demand or rapid downward shifts incosts might lead to rising output.68 Thus,Hotelling’sargument that thenetpriceof fixed-supply goods would rise at the market rate ofinterest degenerates into the general proposi-tion that something is valuable, and thus anasset, only if some combination of immediatepaymentsandcapitalgainsgivesanoverall yieldat least equal to the market rate of interest.

The critical point here is that exhaustibilityintroduces no new market failures into themarket. If the assumptions for pure competi-tion prevail, response to exhaustion is effi-cient. To make matters worse, the impacts ofmarket failure differ depending upon the fail-ure in question. Monopoly still usually pro-duces inefficiently low output; detrimentalexternalities still lead to excess output. Imper-fect capital markets, if interpreted narrowly,might imply excessive output. However, thisproves not to be true in general.

The economic interpretation of the claimthatmarket actorsdemonstrate inadequate con-cern for the future is thatmarket actors demandtoohigharateof returnon investment.69 Asnot-ed earlier, in a simple ex-haustible-resourcemod-el, concern for the future inspires hoarding ofsupply for future generations of consumers.70

Requiringinvestmenttoproduceaveryhighrateof return has the direct effect of making hoard-ing less attractive. If inefficiently high interestrates are reduced, oil production may indeed beslowed because of increased incentives not toproduce.

However, this can be counteracted by theincreased incentives that would arise to investin and operate new producing capacity. Anindirect effect of raising the interest cost ofuti-lizing equipment discourages investment inand utilization of producing capacity. Neithereffect will always outweigh the other. For pro-ducers that are hoarding so much that pricesare well above current production costs, ahigher interest rate reduces the attractivenessofhoarding.When costs are closer toprice, theinvestment-disincentive effect dominates.71

In any case, the theory indicates what

14

When depletioncomes nearer,

wealth-maximizing

resource ownerswould respond byrestricting output

to provide forlater generations.


would happen if demand for a physically lim-ited material lasts forever. Some have arguedthat it is thus a useless theory. It is better tocontend that the theory, properly used, pro-vides guidance about whether exhaustion is apressing problem. The presence or absence ofthe expected results thus gives evidence of theimportance of exhaustion.

Contrary to some assertions oftenmade inthe early years of oil-price increases (seeabove), oil-exporter behavior is better ex-plained by theories of cartelization than ofexhaustion. Exhaustion theory implies thatdecisionswill be consistent over time and thatunilateral producer action is, if anything,preferable. The opportunity to hoard existswhatever other producers do, and indeed, theless that others hoard, the more the actualhoarders benefit. In contrast, cartelizationrequires coordination. Consistent behavioralso is preferable to those hoping to cartelize,but the theory and practice of cartelizationindicates that differences among potentialparticipants often lead to breakdowns.72 Thefitful path of oil prices since 1971 is clear evi-dence that unstable cartelization is the mostlikely situation.

Of course, discussions about oil scarcityare heavily affected by the inherent lack ofhard data. For good economic reasons, dataon the long-run availability of oil and otherminerals do not exist. Information on what isknowable, current production and actuallydeveloped (proved), is often hard to come by(particularly data from fields governed bymembers of the OPEC cartel), and all thedata are characterized by terms that aresometimes quite unclear or misleading.However, Adelman’s work in the area tacitlytreats the issues.73 He first notes the criticaldistinction between exploration and develop-ment. Exploration is the initial and far lesscostly step of locating potentially valuablemineral deposits. Development is the muchmore expensive step of constructing the facil-ities needed to extract the minerals. Adelmansuggests that exploration is steadily under-taken to build up a backlog of sites that arepotentially worth developing. Then, as justi-

fied, the locale is developed. Such develop-ment can continue for decades, and indeedeven centuries, as conditions dictate.

He argues that exploration is an ongoingactivity, driven not by fear of depletion, but byrecognition that good opportunities toreduce costs may exist. Exploration and devel-opment are limited to serving immediateopportunities to produce.

Given this, the actual endowment of mostminerals is unknown. What is known is theamount of proved reserves—the amount indeveloped deposits and the prospects fordeveloping more. Neglect of this fundamen-tal point perennially produces concern, oftenreaching hysteria, on resource availability.

Indicators also exist about the vast physi-cal availability of several alternatives to oiland natural gas such as coal, oil shale, tarsands, uranium supplies as extended bybreeder reactors, hydrogen, wind, and solar.The broad prediction that ultimately theworld economy will move to one or more ofthese alternatives is probably correct but ofno practical value. We simply lack knowledgeof what the optimum outcome will be.Neither the identity of the preferred optionsnor the timing of the transition is knowable.Moreover, the failure as yet to adopt theseoptions reflects the current relatively plenti-ful supply of oil rather than short-sighted-ness.

In any case, the situation produces muchspeculation. Two broad classes of scenariosemerge. In one case adopted by theNPC,mov-ing through coal and perhaps shale and tarsand is undertaken before moving to one ormore non-fossil alternatives. Others wouldskip the first stage. Clearly, the differences liein views of the overall economics of the alter-natives. A critical consideration is whether ornot thedirect costs of the fossil alternatives arelow enough to outweigh the perceived highenvironmental costs.

In sum, the theory and practice of deple-tion strongly indicate that a market solutionis vastly superior to government interven-tion.

15

Discussionsabout oil scarcityare heavilyaffected bythe inherent lackof hard data.


Environmental Issues

Dealing with environmental issues such asglobal warming is tricky because the centralissues lie far outside economics. However,neglect is inappropriate because importanteconomic considerations exist.

The case for altering fuel-use practices tofight global warming involves several premis-es. The starting point is that global tempera-tures are rising. The critical second proposi-tion is that human activity is a major cause ofthese rises. The third is that these tempera-ture increases are harmful. Fourth, it is pre-sumed that restricting the heat-raising activ-ities is the most efficient response. Only thefirst of these is well established.

In viewing the debate, it is necessary to getpast the obfuscation regularly used to throttlediscussion. The world does not neatly divideintodisinterestedpartiesnoblypursuing truth,justice, and the American way and interestgroups with selfish aims. It is more realistic toview all participants as possessing an agendathat they are vigorously pursuing. A “specialinterest” charge is a standard tactic to discreditopposition. Environmental groups have a biastowards finding damages to the environment.Governments have a slant toward encouragingthe continuation and expansion of their activi-ties. Universities want to secure research fund-ing. Corporations and trade associationsbelieve that their industries make valuable—and indeed, indispensable—contributions tothe economy. All this should be viewed suspi-ciously. All will overdo; some may be right attimes.

Theenvironmentalmovement isparticular-ly suspect because of its extensive history ofoverreach. Leaving aside phony crises such asDDT, Love Canal, and Alar, alarmist declara-tions are usually built uponmountains ofmis-information.74 Certainly,worries aboutdisasterfrom the operation of nuclear plants provedvirtually baseless.75 Studies surrounding acidrain revealed that fears about the effects onforests and lakes were unjustified.76

When considering the issue of climate

change, onemust always keep inmind the biasimparted by the dominance of governmentsupport in research financing. That backingtacitly rests on the presumption that the casefor global warming will be confirmed. Con-cerns are reinforcedhereby indications that cli-mate scientists who are not heavily involved inmassive studies are skeptical that human activ-ities are causing dangerous global warming.77

Whatever the causes, the climatologicaleffects and their economic consequences areunclear. The possibility exists that beneficialeffects will dominate. Even if not, Goklanycalculates that mitigating the effects of glob-al warming will be much cheaper than green-house gas emission reduction.78

The Economics ofConsumption RegulationThe proposals for regulations to reduce

energy consumption, promote new technolo-gies, and develop scientific and engineeringcapabilities can most charitably be viewed asimperfect ways to respond to the allegedunder-pricing of oil. An alternative interpre-tation is that market imperfections causeinefficient responses even to correct energyprices. Neither argument is satisfactory.

Two main rationales exist for concernsover energy-consumption choices. The first isthe inefficient-capital-market contentionjust criticized. The second is the assertionthat consumers are inadequately informedabout energy options. This is an argumentwith weak theoretic support and unaccept-able empirical analyses.

Concern about inefficient market responseto price signals has emerged from new acade-mic efforts to discover ways in which marketoutcomes are unsatisfactory.79 The prolifera-tion of these efforts can be explained by twophenomena. One is the simple academic pres-sure to develop new ideas. The other is a desireto counter the onslaught on oldermarket-fail-ure theories. Discontent with older claimsabout market failure has become vigoroussince at least the 1970s.Many economists now

16

Proposalsfor regulations toreduce energyconsumption,promote new

technologies, anddevelop technicalcapabilities canmost charitablybe viewed as

imperfect ways torespond to thealleged under-pricing of oil.


are skeptical about our ability to determinewhether inefficiency does or does not prevailand about the feasibility of devising a satisfac-tory remedy. So many false accusations andinappropriate cures have emerged in the pastthat skepticism is essential.

Newer concepts of market failure, however,are considerably more problematic. The newtheories deal with more complex cases thanwere previously considered. The most relevanthere are those that purport to demonstratethat asymmetric information between buyerand seller often produces unsatisfactory mar-ket outcomes. A critical way in which the newtheories differ is that, unlike older work thatidentified conditions that always led to ineffi-ciency, these new models deal with situationsthat may or may not produce inefficiency.

Whilebotholdandnewtheoriesaredifficultto verify (and remedy via government interven-tion), verification is more difficult with thesenew theories, in which proof of undesirableeffects is more difficult to ascertain.

The most relevant critique of these newertheories of market failure is that of Northwest-ern University economist Daniel Spulber.80

Spulber presents his analysis in two parts. Thefirst begins by showing, as would be expected,that no inefficiency arises if the standardassumptions of pure competition with com-plete information prevails. The existence ofmonopolymayormaynotproduce inadequate(or excessive) response. The second part dealswith the inefficiencies thatmightarisewithvar-ious types of knowledge gaps by the partici-pants. Spulber isquite careful to recognizeboththat private alternatives to public interventionexist, andthat theprospects forpublicdesignofefficient intervention are dubious. He con-cludes that public supply of information toremedy asymmetric information is probablypreferable to directly regulating transactions.

If anything, Spulber’s critique of these newtheories does not go far enough; too many ofthe analyses that he cites, for instance, postu-late problems that are unlikely to arise. Forexample, Spulber notes Akerlof’s work on themarket forused vehicles, andhowdifficult it isfor buyers to detect “lemons”—a problem that

leads to sub-optimal prices for all used vehi-cles.81 However, economist Eric Bond’s exami-nation of the used-truck market suggestedthat mechanisms existed to appraise used-truck quality.82

What is critical here is that these newer the-ories of market failure apply to transactionswhere the relevant knowledge is difficult forone party to the transaction to secure. Thishardly applies to energy transactions. Con-sumers can readily determine the energy-usecharacteristics of all the energy-using equip-ment that they purchase (the government per-haps deserves credit for forcing disclosure).Once information problems have been solved,performance mandates (such as automotivefuel efficiency standards) are indefensiblebecause they violate basic (and sound) eco-nomic principles about the optimal manner inwhich choices should be made. No one can bea better judge of what is best than a well-informed consumer, given that performancepreferences and consumption patterns vary byindividual.Neithergovernmentagencieswithamandate to reduce energy consumption norconservationists devoted to the cause of lessenergy are to be trusted. In short, affection forperformance standards is very bad economics.

Viewing what passes for the empirical litera-ture on these matters inspires total rejection ofthecase for intervention.Forover threedecades,assorted research groups have generated paperstudies purporting to prove the existence ofmassive amounts of neglected opportunitiesthat would economically reduce energy con-sumption. The critical problem is that none ofthese groups has experience in implementingenergy choices.83 Thus, the other logical possi-bility, that these studies are incorrect, seemsmore plausible. The situation is not helped bythewillingnessofconservationists toextendthecriticism about inefficient energy use beyondsmall-scale users to large consumers and prod-uct producers. These large-scale users havegreater incentives than households to investi-gate opportunities to reduce energy consump-tion and have organized to do so.

The academic literature on governmentintervention to address these sorts of alleged

17

Newer theoriesof marketfailure apply totransactionswhere the rele-vant knowledge isdifficult for oneparty to thetransaction tosecure. Thishardly appliesto energytransactions.


market failures is extensive. A notable review ofelectric-utilityenergy-conservationprogramsbyMIT economists Paul Joskow and DonaldMarron found serious flaws in the manner inwhich the benefits from these programs werecalculated.84 The central elementof energy-con-sumptioncontrol—fuel-efficiencystandards forautomotive vehicles (known as corporate-aver-age-fuel-economy standards, or CAFE), is wide-ly, but not universally, criticized as undesirable,even if the alleged market-failure problems pre-vailed.85 The main problems are effects of thestandards on other aspects of automobile per-formance, such as safety,86 and the incentives toincrease automobile use from the highermileage and thus low per mile travel cost.87

A further drawback, in practice, was creat-ed by Congress when it established morestringent rules for automobiles than for lighttrucks. As should have been expected, thisspurred the substitution of light trucks forautomobiles, and new types of trucks withproperties more like automobiles emerged.

The literature on CAFE suggests that thecase for such standards critically depends onmassive consumer neglect of the value of fuelsavings. For example, a curiously ambivalentarticle written by Resources for the Futureeconomists Fischer, Harrington, and Parryshows that with consumer awareness, CAFE isat best redundant and has negative effects if itdiverts investment from improving othercharacteristics ofmotor vehicles. Nevertheless,the authors support modest tightening ofCAFE because of other supposed benefits thattheir analysis did not capture. Those benefits,however, seem more speculative than the con-sumer-ignorance arguments, about which theauthors were properly skeptical.88

Big Oil and the Speculators:The Great Excluded IssuesPoliticians often rail against the role played

by large privately owned oil companies andspeculators in energy markets. Blue-ribbonpanels have neglected the subject. In the NPCcase, this was due to the rules to prevent collu-

sion under which the Council operates. Theneglect elsewhere, by definition, indicates thatthese other groups found the questions unim-portant. Given the general ineptitude of theseefforts, dumb luck is as likely an explanationas a sudden attackof good sense.However, thepersistence of the charge that oil companiesand financial speculators routinely engage inprice fixing, market manipulation, and collu-sion necessitates mention here.

There is nothingnewabout the complaintsbeing lodged against “Big Oil” or Wall Streetspeculators. Assertions of mischief-makingalways arise when speculators are active inmarkets undergoing major changes. However,suchassertionshaveno substance. Efforts dat-ingback to the1970s and resuming in the21stcentury have consistently failed to supportcharges of energy market rigging by privatelyowned companies operating in the UnitedStates.89 The charges against speculators areexercises in economic illiteracy. Speculation isa bet about future prices. The bet can be wononly by correctly predicting prices. These,moreover, are wagers in games of skill.Speculators persist because they are adept atanticipating price trends. Current prices areaffected only if the high futures price inspiresincreased stockpiling, which has not been thecase. The attacks on both oil companies andspeculators are simply a demagogic way toexpress frustration. Confiscating profits thenremoves the incentives of companies and spec-ulators to apply their skills to the market. TheOPEC countries, which are the real culprits,are beyond congressional reach, but oil com-pany executives and financial company execu-tives must respond to subpoenas.

The Exile ofFirst-Best Alternatives

Modern economic analysis, particularly ininternational trade theory, labors mightily tomatch solutions to problems. At least in thisliterature, the writers are careful to limit theirattention to policy measures that are normallyemployed, and which might work in the cases

18

Speculatorspersist becausethey are adept atanticipating price

trends.


considered.90 Hence, analysts are interested inpicking thepolicy instrument thatmostdirect-ly solves theprobleminquestion.Analystsonlyconsider feasible policy instruments thatwould have the desired effect. Thus, discussionimmediatelybeginswithexaminationofwhichqualitatively feasible policy is best.

In this literature, then, only stimulatingpolicies are considered when stimulation isthe goal, and similarly, only retarding policiesare considered when restriction is the objec-tive. For instance, subsidies stimulate thatwhich is subsidized, while taxes discouragethat which is taxed. Industries not targetedby the subsidies feel the opposite effect. Forinstance, a tax on coal stimulates natural gas.

In thepresent case, the allegedproblems aredangers of oil imports and of global warming.Thus, if the fears are valid, the most directapproaches are to tax imports andgreenhouse-gas emissions.

Unfortunately, thebundleofpolicy interven-tions embraced by the NPC and most others inthe business of pontificating about energy poli-cy does not directly address the identified prob-lems. For instance, taxes on oil or gasoline, orfuel efficiency standards for new vehicles, dis-courage the consumption of both internationaland domestic oil. CAFE standards have the fur-ther drawback of raising the cost of owning amotor vehicle, but simultaneously lowering thecost of using that vehicle. It becomes unclearwhether energyusewill rise or fall, and the sameholdstrueforotherperformancestandards.Thewide use of such standards means that theyextend to areas such as electric appliances—andeven toilets—inwhich oil use is negligible. Thus,they mainly hit domestic consumption of fuelsthat, at least in many cases, the usage shouldprobably be encouraged.

Market Failure vs.Government Failure

A key aspect of the modern economic the-ory of intervention is skepticism aboutwhether governments in fact have the abilityand desire to remedy market failures and

increase efficiency. As a result, theories ofgovernment failure have proliferated.

Columbia economist Jagdish Bhagwati hasneatly summed up the standard uses of mar-ket-failure arguments as the “puppet governmentapproach.”91 The old-fashioned textbook gov-ernment possesses far more prescience andacceptance of economic principles than doactualgovernments.Realgovernments lack thecompetence and the motivation to increaseefficiency. Moreover, intervention is expensiveto design and operate properly. Thus, the inef-ficiencies must be great for regulation to bedesirable.

A remarkable article by Ronald Coase, “TheProblemofSocialCost,” is the critical sourceofthe last point and a much more modernappraisal of intervention.92 In the essay, Coasedealt with a much-discussed but badly datedanalysisof “externalities”byA.C.Pigou, a long-time professor of economics at CambridgeUniversity. Externalities are the incidentaleffects of economic actions on people who arenot directly involved. These can be harmful, aswith pollution and noise, or beneficial, as withpollination of plants by bees.

Coase emphasized two defects of Pigou’sanalysis. First, Pigou presumed that govern-ment intervention always was needed, butCoase provided numerous examples of howcures to externality problems were securedprivately. Second, Pigou asserted that, whenconfronting positive externalities (where bydefinition the costs to society were lowerthan the costs to the private producers orconsumer), a subsidy to the producer or con-sumer was appropriate. Conversely, negativeexternalities should be taxed. Coase showedthat this also was wrong; subsidizing theabatement of a detrimental externality wouldproduce the same result as a Pigouvian tax.

Coase’s insights proved remarkably imper-vious to criticism. Two potential problems,however, are evident. First, Coase tacitlyassumes that thebeneficiariesof the taxarenotso different from the beneficiaries of the sub-sidy that demands shift. Second, an implicitfurther condition of optimum externalityresponse is that the response should ensure

19

The bundleof policyinterventionsembraced by theNPC andmostothers in thebusiness ofpontificatingabout energypolicy does notdirectly addressthe identifiedproblems.


that only firmswhose total social value exceedstheir total social costs should survive. The cor-rect social policy requires additional measuresto attain this goal.93

Coase is well aware that the choice of pol-icy response affects the welfare of thoseinvolved. By example, he shows that thoseharmed by the externality are not always theones whom it is appropriate to compensate.In some cases, these victims knowinglymoved near an existing externality-produc-ing entity, about which the newcomer shouldhave been aware.

Coase moves so tersely through the argu-ments thatmany commentators overlookedormisunderstood his discussion of why privateaction may not resolve the externality prob-lem.94 Coase argued that when a large numberof people are involved, the transaction costsassociated with providing for a remedy couldprove to be so steep that private action wouldbe difficult to implement. However, he pre-sented two objections to the presumption thatsuch high transaction costs justified govern-ment action. First, with sufficiently high trans-action costs, even if the government can actmore cheaply than private groups, the totalcosts of intervention will still exceed the bene-fits. High enough transaction costs can be abarrier to both private and public externalityremedies. Second, even if this is not true, apub-lic solution isnotnecessarilypreferable toapri-vate solution. Given the limitations of govern-ments, the inefficiencies of a private solutionmay be less than those of a public one. In a fol-low-up article, “The Lighthouse in Econom-ics,” Coase showed that the traditional asser-tion that lighthouses were a clear example of agood that had to be supplied by governmentwas historically invalid. In the United King-dom, the government took over lighthousesonly after a private association successfullyestablished a system of lighthouses.95

GeorgeStigler observed thatCoase’s analysisapplied to all market failures.96 Stigler stressedthat with low enough transaction costs, marketfailures could all be overcome privately. Coase’scaveats about the implications of high transac-tions also apply to all interventions.

While Coase seems never to have made thelinks explicit, these arguments are closelyrelated to another celebrated contribution tothe literature—Paul Samuelson’s 1954 analysisof the justification of government action.97

Samuelson employed the concept of “public-ness,” in which a good could not be madeavailable exclusively to individuals; if one per-son received it, everyone did. Everyone in soci-ety then would benefit from the private con-sumption of a public good. Private solutions,however, would fail to adequately recognize allof these benefits. Thus, the governmentshould provide the goods.

Coase’s analysis can be restated as indicat-ing that it is only when publicness wasinvolved that government intervention toaddress externalities might be justified. Coasecan then be credited with creating a differentand superior theory of government action: it isonly when transaction costs are high (but notby a degree to render action unprofitable) thatgovernment interventionmight be desirable.

The advantage of Coase’s approach is thatit leads to a consideration of critical problemsthat the Samuelson analysis ignores. First,considerable evidence exists that politicianshave motivations far different from attainingan efficient supply of public goods.98 Second,theCoaseproblemof attaining anoptimumisformidable. Governments often lack the com-petence to identify and optimally correct inef-ficiencies. Both these difficulties are extensive-ly reviewed in the economics literature, but thebad-motivation argument is stressed morethan the limited-ability concern.99

The adoption of inappropriate objectives isthe subject of a very rich literature that exam-ines the motivations of political actors. Thestarting point is Schumpeter’s observationthat, in a democracy, political actors are pri-marily engaged in a competition for votes.100

As numerous subsequent observers have not-ed, onekeyway to secure votes is to legislate an(economically) inefficient policy—in which afew beneficiaries each receive gains largeenough for them to note—by creating lossesfor many others that are too small for any tonotice.101

20

It is only whentransaction costsare high (but notby a degree torender action

unprofitable) thatgovernment

interventionmightbe desirable.


Some observers, notably Harvard econo-mist Joseph Kalt, have examined the proposi-tion that, in some cases, action arises onlyfrom an ideological preference for interven-tion by legislators whose constituents lacksignificant interest in an issue.102 Kalt and col-laborators have found statistical support forthis proposition.103 A simpler possibility isthat politicians instinctively believe that if aproblem arises which receives extensive atten-tion, they can—and should—intervene.

The problem of determining and satisfyingdemands for public goods is more looselytreated in the literature. Economists LudwigvonMises, F. A.Hayek, andRonaldCoase haveall argued that, among other things, govern-ments cannot readily secure the informationneeded for efficient intervention.104 Coase’streatment is far less extensive, but also farmoregeneral, than those of Mises or Hayek. Theirextended writings on socialist calculation, nev-ertheless, should have made clear the difficul-ties of optimally devising plans for any kind ofgovernment spending. The debate was startedby an assertion by Mises that a socialist statecould not be efficient because it lacked infor-mation about the demands for commodi-ties.105 In the most celebrated response, OscarLange106 replied that this problem could beresolved by establishing planning boards tomeasure demands and set prices appropriatefor those demands. Hayek answered Lange bynoting that this was a much more cumber-some approach than an unregulated market-place.107 Misesasserted that the solutionwouldbreak down for producers’ goods because ofconcentration of ownership in state monopo-lies.

In any case, Langewas changing the subject.His system depended upon the competence ofthe planning board, which, after all, could beimposed on top of any ownership pattern. Theplanning board as Lange envisioned it, howev-er, is the expansion of the public utility com-mission concept. Thus, it may be asked why atechnique thatworks badlywhen it treats a fewindustries could well treat the whole economyany better. Nevertheless, the literature in thisarea strangely evadesdiscussionof the full con-

sequences of this knowledge problem.108 Inpractice, the problem is herculean.

Reviews of specific policies have illustrat-ed the point. Richard Posner’s wide-rangingreview of the regulation of natural monop-oly, for instance, notes many of the problemsrelated to securing the informationneeded toattain efficient results.109

In any case, these basics suggest further rea-sons to treat recommendations for energyintervention by theNPCandothers skeptically.Not only are their proposed remedies nth-bestmeans of addressing identified problems, theyfurther assume perfectly informed, hyper-effi-cient government responses that are implausi-ble in the extreme.

Conclusion

Bad theory, bad history, and bad practicemar energy (and most other public policy) dis-cussions. The shock of 9/11 has badly aggra-vated these problems. Across an absurdlybroad range of issues, panic over remote possi-bilities of terrorist actions has producedhyste-ria. Thepresent paperwaswritten in themidstof a political campaign in which these prob-lems seemed particularly severe. As suggestedhere, energy, as is usually the case, hasnotbeenspared. Even a group that should have knownbetter (the NPC), directed by the former headof a companyknown for its astuteness (Exxon-Mobil), could not refrain from a plunge intothis frenzy.

Economic analysis shows both the defectsof public policy and why these faults areimpervious to analytic objection. Interferencewith international trade, for example, is rou-tinely attacked by economists and adopted bypoliticians. Ill-advised efforts such as that ofthe NPC are regrettable but predictable.

Economists periodically debate whethertheir efforts are justified. Surely, without seri-ous economic analysis, what comprises desir-able reform remains unknown. Somethingmust stand against the temptation to seeknarrow political gains. Even those economistswho are particularly concerned about govern-

21

EconomistsLudwig vonMises,F. A. Hayek, andRonald Coasehave all arguedthat, amongother things,governmentscannot readilysecure theinformationneeded forefficientintervention.


ment failure are divided about whether theirefforts are worthwhile. Some stress the manyinstances in which the advice was ignored;others believe that enough good results ariseto provide the encouragement to continue.

Clearly, the analysis here is grounded in thelatter view. Enough successes, both big andsmall, have arisen to inspire hope. Opportun-ities for improvement periodically but unpre-dictably arise, and economic analyses that pro-vide guidance can only help assist the response.Moreover, bad policy imposes wastes that thepower to tax allows to persist. This ability to erris not unlimited. Intolerable strains do emerge.Thus, economists should continue the on-slaught on bad policy to anticipate openingswhen they occur. Perhaps future study groupscan be weaned away from ideas that harmthemselves and everyone else.

NotesFor more works by Richard L. Gordon, see, forinstance,AnEconomicAnalysisofWorldEnergyProblems(Cambridge, MA: MIT Press, 1981); Regulation andEconomic Analysis: A Critique over Two Centuries(Boston: Kluwer Academic Publishers, 1994); “TheEconomics of Optimal Self-sufficiency and EnergyIndependence,MineralWarsandSoftEnergyPaths,”Materials and Society 7, no. 2 (1983): 225–35; “UsingMarkets to Solve Natural Resource Problems,” inResourcesandWorldDevelopment, ed.D. J.McLarenandB. J. Skinner (New York: John Wiley, 1987), pp.453–72; “Energy Intervention after Desert Storm,”Energy Journal 13, no. 3 (1992): 1–15; “Energy,Exhaustion, Environmentalism, and Etatism,”Energy Journal 15, no. 1 (1993): 1–16; and “Law andMacroeconomics,” in Encyclopedia of Law andEconomics, Volume I: TheHistory andMethodology of Lawand Economics, ed. Boudewijn Bouckaert and GerritDe Geest (Cheltenham and Northampton, UK:Edgar Elgar, 1999), pp. 660–93.

1.Most notably inNational EnergyPolicy, Report ofthe National Energy Policy Development Group(Washington: 2001), henceforth referred to as“the Cheney report,” since it was produced by aWhite House task force that was directed by VicePresident Dick Cheney.

2.National PetroleumCouncil,HardTruths: Facingthe Hard Truths about Energy: A Comprehensive Viewto 2030 of Global Oil and Natural Gas (Washington:2007). The present Policy Analysis was initiated asa response to theNPC’s vigorous promotion of its

report, but it was implemented as a review of theoverall debate on energy. Since the NPC reportprovides the fullest, most coherent presentationof the interventionist agenda, it is used here as aprime example.

3. National Commission on Energy Policy, Endingthe Energy Stalemate: A Bipartisan Strategy to MeetAmerica’s Energy Challenges (Washington: 2004).Despite its name, the commission was funded byprivate foundations (Hewlett, Pew,MacArthur, andPackard) rather than the United States govern-ment. The report presents, without justification,policy proposals similar to the NPC and, despitethe need for further support, was backedupby oneof themost incoherent sets of supportingpapers ofany energy study of which I am aware.

4. National Security Consequences of U.S. Oil Depend-ence (New York: Council on Foreign Relations,2006). The task force that produced the CFRreport was directed by James Schlesinger and JohnDeutch. Schlesinger, a Ph.D. economist, had sever-al important government jobs, includingbeing thefirst Secretary of Energy. Deutch, an MIT chem-istry professor, also had government service,including several DOE posts and the CIA director-ship. Although it should have known better, thetask force concentrated on reducing gasoline con-sumption rather than directly taxing oil imports.Specific proposals included an increase of the fed-eral gasoline tax, tightened corporate-average-fuel-economy (CAFE) standards, and tradable permitsto use gasoline. The CFR report also calls for for-eign-policy initiatives similar to those championedin the NPC and Cheney reports. The CFR report,however, only briefly (pp. 26–31) discusses whyimports are dangerous; it spends most of its timeproposing cures.

5. Milken Institute, Financial Innovations for Achiev-ing Energy Independence (Santa Monica, CA: 2007).This report has its analysis backward. It proposesfinancing techniques to promote energy alterna-tives without assessing the desirability of thesedevelopments.

6. This listing is limited to reports generated byorganizations rather than by freelance individu-als. Their inclusion would too greatly expand thediscussion even if only those dealing with overallenergy prospects were covered.

7. As more fully discussed later, because of pres-sures to broaden input into the NPC, the partici-pants actually came from a wide variety of areas,mostly outside the oil industry. However, theleading oil industry participants took an activerole in promoting the findings. The promotionaleffortwas probably amajor factor in the attentionthat was initially received.

22

Bad theory,bad history, and

bad practicemar energy

(andmost otherpublic policy)

discussions. Theshock of 9/11 hasbadly aggravatedthese problems.


8. This misuses the concept of efficiency.Efficiency occurs when the use of one input isreduced without increasing another. It is unclearwhether this is true for energy-saving actions.Thus, when I discuss forced reductions in energyuse, I avoid the term efficiency. The NPC reportapparently does not rule out reduction by taxa-tion, but the language used implies a preferencefor tighter performance standards. It is arguedbelow that taxes are preferable to standards.

9. National Petroleum Council, p. 6.

10. Ibid., pp. 5–6.

11. Concern over personnel availability in somerealms is a hearty perennial in policy proposals,dating back at least to the 1957 U.S. panic overthe Soviet Union’s launch of its Sputnik satellite.More broadly, it is a variant of the standard claimof interest groups that the marketplace does notefficiently meet the groups’ needs.

12. Ibid., p. 23.

13. Ibid., p. 24. This inflation of proposed respons-es is endemic to “blue-ribbon” panels of all sorts.

14. A more banal and innocuous set of recommen-dations relates to capabilities. The areas of concernare infrastructure needs, science and technologycapabilities, research and development activities,and energy data. Infrastructure needs are to be thesubject of a Department of Energy study, and theEnergy Information Administration is told to col-lect infrastructure data. The main idea in the otherareas, predictably, is to do more. In the data area,not only should information on current activitiesbe increased, but extensive studies of resource avail-ability are proposed. This reflects more of the eco-nomic illiteracy that mars the report. These studiesare not undertaken for the very good reason that ina free-market economy, resources and the facilitiesto develop them are made available without anysuch global information. Along with science andengineering capabilities, the report makes furthersuggestions of eased immigration and changes intax and retirement plan rules in order to fosterwork by retirement-age people.

15. Ibid., p. 228.

16. Ibid., p. 227.

17. Even so, the NPC report has the distinction ofbeing better than the report of the National Com-mission on Energy Policy. Vice President Cheney’s2001 take on the subject avoids clear analytic errorsby eschewing analysis altogether. However, by mak-ing more suggestions than the NPC, includingmany on the electric power industry and foreign

policy, the Cheney report presents more bad ideas.It lacked supporting material.

18. The Cabinet Task Force on Oil Import Con-trols, praised below, reached a solid conclusion bypresenting the divergent views of the members.Good staff does not always lead to a satisfactoryreport, and good reports are not demonstrablymore influential than bad ones.

19. A possible exception is the treatment of glob-al warming. It would be correct to argue thatintervention is appropriate if the assertions aboutlarge climate damages due to fuel use were cor-rect. The NPC report’s sketchy, narrowly-focusedtreatment of global warming, however, never risesto a clear policy position.

20. M. A. Adelman, The World Petroleum Market(Baltimore, MD: Johns Hopkins University Press,1972).

21. M. A. Adelman, The Genie out of the Bottle: WorldOil since 1970 (Cambridge, MA: MIT Press, 1995).An anthology of his oil writings also was pub-lished: M. A. Adelman, The Economics of PetroleumSupply: Papers by M. A. Adelman 1962–1993 (Cam-bridge, MA: MIT Press, 1993).

22. U. S. Cabinet Task Force on Oil Import Con-trol, The Oil Import Question: A Report on theRelationship of Oil Imports to the National Security(Washington: Government Printing Office, 1970).

23.DouglasR. Bohi andMiltonRussell, LimitingOilImports: An Economic History and Analysis (Baltimore:Johns Hopkins University Press, 1978); Douglas R.Bohi and W. David Montgomery, Oil Prices, EnergySecurity, and Import Policy (Washington: Resourcesfor the Future, 1982); Douglas R. Bohi, Energy PriceShocks and Macroeconomic Performance (Washington:Resources for the Future, 1990); and Douglas R.BohiandMichaelA.Toman,EnergySecurityasaBasisfor Energy Policy (Boston: Kluwer AcademicPublishers, 1995). The American Petroleum Insti-tutedistributed themanuscript asapamphletwith-out charge; that version was used here. At the time,Bohi and Toman were on the staff at Resources forthe Future, but privately prepared the report for theAmerican Petroleum Institute. Resources for theFuture had a policy against accepting support frominterested parties that failed to exclude governmentfunding.

24. Parry, often with co-authors, has produced aseries of useful studies, one of which is cited below,on the wisdom of various energy-related publicpolicies, particularly involving motor vehicles.

25.DanielH.NewlonandNormanV.Breckner,TheOil Security System (Lexington, KY: Lexington

23


Books, D. C. Heath, 1975); David A. Deese andJoseph S. Nye, eds., Energy and Security (Cambridge,MA: Ballinger Publishing Company, 1981); JamesPlummer, ed., Energy Vulnerability (Cambridge, MA:Ballinger PublishingCompany, 1982); AlvinL.Almand Robert J. Weiner, eds., Oil Shock: Policy Responseand Implementation (Cambridge, MA: BallingerPublishing Company, 1984); George Horwich andDavid Leo Weimer,Oil Price Shocks,Market Response,and Contingency Planning (Washington: AmericanEnterprise Institute for Public Policy Research,1984). Newlon and Breckner are the first of whomI am aware to blame the inadequacy of inventorieson price controls. The other books discuss theproblems of tapping the stockpile optimally.

26.His keyworks are: JamesD.Hamilton, “Oil andthe Macroeconomy since World War II,” Journal ofPolitical Economy 91, no. 2 (April, 1983): 228–48;JamesD.Hamilton“What Is anOil Shock?” Journalof Econometrics 113 (2003): 363–98; and James D.Hamilton and Anna Maria Herrera, “Oil Shocksand Aggregate Macroeconomic Behavior: the Roleof Monetary Policy,” Journal of Money, Credit, andBanking 36 (April, 2004): 265–86.

27. Robert L. Bradley, Jr., Oil, Gas & Government:The U.S. Experience (Lanham, MD: Rowman &Littlefield, 1995).

28. Adelman’s 1995 book makes these points.

29. As discussed below, further considerationsrelate to possible consequences of dealing withimported oil. Theories have proliferated onways tocounteract monopolistic behavior of oil exportersand on the alleged macroeconomic effects of oilshocks.

30. This point is often made in the energy eco-nomics literature; the previously cited Resourcesfor the Future studies and Adelman’s works pre-viously cited are key examples.

31. U.S. Federal Energy Administration, ProjectIndependence Report (Washington, 1974).

32. With the key exception of Oliver E.Williamson, the literature on slack is maddening-ly imprecise. Williamson, however, developed asolid analysis of the behavior of managers whowere able to divert profits from stockholders. Hepoints out that the best strategy for managers inthis situation is to maximize profits and thendivert the money to themselves in wages andfringe benefits. He notes that cases can arise whenthe fringe involves undertaking an unprofitableventure. A firm’s output decisions would bealtered undesirably when it hires employees whowill produce more costs than revenues. Oliver E.Williamson, The Economics ofDiscretionary Behavior:

Managerial Objectives in the Theory of the Firm(Chicago: Markham Publishing Company, 1967;Englewood Cliffs, NJ: Prentice-Hall, 1964).

33. Again Adelman’s 1995 book is a key sourceamong the many presentations of this argument.The long lines at gas stations in the United Statesduring the embargo were due to the imposition ofprice controls on gasoline and their enforcementby rigid rules for distribution. Price controls alwaysthwart the role of price signals in supply allocation.Messy rules must be imposed to deal with theexcess of the quantity demanded over the amountavailable.

34. This, too, is another argument of Adelman’s1995 book.

35. Adelman’s warning that the U.S.-Saudi specialrelationship would prove a to be a fraud whenev-er seriously tested is still widely ignored, as waswell illustrated by both President George W.Bush’s May 2008 failure to inspire Saudi outputincreases and Congressional complaints aboutthe inadequacy of the effort.

36. The critical works on this again are Adelman’s.Bothhis oil books are relevant, as isM.A.Adelman,“Is the Oil Shortage Real? Oil Companies as OPECTax-Collectors,” Foreign Policy 9 (1973): 69–107(reprinted in Adelman 1993, pp. 329–57). See alsoAnthony Sampson, The Seven Sisters: The Great OilCompanies and the World They Shaped (New York:Viking Press, 1975). Forbes did a remarkable report-ing job that showed how the State Departmentblindly fostered acquiescence with oil-countrydemands. “Don’t Blame theOil Companies, Blamethe State Department,” Forbes, April 15, 1976. TheState Department seems to have felt that this wasthe least badpossible outcome, butForbes feels thatthe State Department overestimated the strengthand resolve of the producing countries. The StateDepartment characteristically failed to compre-hend the importance of preserving competition.

37. M. A. Adelman, The World Petroleum Market(Baltimore, MD: Johns Hopkins University Press,1972). M. A. Adelman, The Genie out of the Bottle:World Oil since 1970 (Cambridge, MA: MIT Press,1995).

Akins’s implicit rebuttal toAdelman canbe foundin James E. Akins, “The Oil Crisis: This Time theWolf isHere,” ForeignAffairs 51, no. 2 (April, 1973):462–90. I can attest from direct experience thatAkins did not understand the limitation of hisknowledge and was incapable of absorbing thesubstantial amount of advice available to him. In1968, I presented a paper at an invitation-onlyseminar in Colorado Springs that was attendedonly by experienced observers of energy markets. I

24


resorted to standard economics to note that ifdollar problems became severe, devaluationwould arise. Akins lecturedme as if I were a stupiderring schoolboy on why this would never hap-pen. Of course, it did happen in 1971. Richard L.Gordon, “Without Rudder Compass orChart–The Problem of Energy Policy Guide-lines,” in The Political Economy of Energy andNational Security, S. H. Hanke, ed., published asQuarterly of the Colorado School of Mines 64, no. 4(October, 1969): 29–51.

38. A further complication is “discrimination,”the ability to charge different prices for the sameproduct to different parties. Whatever its role inthe history of the oil industry and in special dealsby some producers, it is not a factor in sales tolarge consuming countries.

39. This story appears in every one of the manyhistories of world oil of which the most celebrat-ed example is Daniel Yergin, The Prize: The EpicQuest for Oil, Money & Power (New York: Simon &Schuster, 1991).

40. Douglas R. Bohi and Michael A. Toman,Energy Security as a Basis for Energy Policy (Boston:Kluwer Academic Publishers, 1995).

41. Disputes arose about what parts of the U.S.industry benefited. Clearly, the small-scale pro-ducers were preserved by the combination ofimport quotas and state regulations favoring out-put by such smaller scale producers. One issuethen is whether the benefits of high prices to larg-er producers offset the output reductions by largefirms inherent in the state favoritism towardsmaller producers. A second issue is the impact oncompanies with substantial foreign operations.Adelman’s 1972 book argues that the policy hurtall but the small producers.

42. Paul W. MacAvoy,CrudeOil Prices asDeterminedby OPEC and Market Fundamentals, (Cambridge,MA.: Ballinger Publishing Company, 1982) is amajor example of doubts about OPEC’s role. A.D. Johany, The Myth of the OPEC Cartel (New York:John Wiley and Sons, 1980) presented a moreelaborate theory based on the wildly implausibleassertion that the transfer of control to the coun-tries implied greater concern about hoardingresources. As Adelman’s 1995 book aggressivelyargued, the greater foresight assertion in unten-able; it is shown below that greater foresight neednot lead to lesser production.

43.M.A.Adelman, “TheClumsyCartel,”TheEnergyJournal 1, no. 1 (January, 1980): 43–53. Reprinted inM. A. Adelman, The Economics of Petroleum Supply:PapersbyM.A.Adelman1962–1993 (Cambridge,MA:MIT Press, 1993).pp. 407–16.

44. This was not the end of the evolution, but thatis not critical here. A good survey, organized as anexamination of the different macroeconomicapproaches, is Brian Snowdon and Howard Vane,Modern Macroeconomics: Its Origins, Development,andCurrent State (Cheltenham and Northampton,UK: Edward Elgar, 2005). Further insight is pro-vided in Brian Snowdon and Howard Vane, eds.,An Encyclopedia of Macroeconomics (Cheltenhamand Northampton, UK: Edward Elgar, 2002).

45. John Maynard Keynes, The General Theory ofEmployment, Interest andMoney (NewYork:HarcourtBrace; London: Macmillan and Company, 1936).

46. J. R. Hicks, “Mr. Keynes and the ‘Classics’: ASuggested Interpretation,” Econometrica 5, no. 2(April, 1937): 147–59. The resulting literature issummarized and synthesizedbest inDonPatinkin,Money, Interest andPrices, 2nd ed. (NewYork:Harperand Row, 1965). A good appraisal of the debatesappears in Axel Leijonhufvud, On Keynesian Eco-nomics and the Economics of Keynes: A Study inMonetary Theory (New York: Oxford UniversityPress, 1968).

47. Milton Friedman and Anna J. Schwartz, AMonetary History of the United States, 1867–1960(Princeton, NJ: Princeton University Press, 1963).

48. Robert E. Lucas Jr., Studies in Business CycleTheory (Cambridge, MA: MIT Press, 1981).

49. For the key writings of a cross-section of thecontributors to this development, see Robert E.Lucas Jr. and Thomas J. Sargent, eds., RationalExpectations and Econometric Practice (Minneapolis,MN: University of Minnesota Press, 1981).

50. Ben S. Bernanke, Mark Gertler, and MarkWatson, “Systematic Monetary Policy and theEffects of Oil Price Shocks,” Brookings Papers onEconomic Activity, no. 1 (1997): 91–157.

51.RobertB.Barsky andLutzKilian, “DoWeReallyKnow That Oil Caused the Great Stagflation? AMonetary Alternative,” NBER MacroeconomicsAnnual 16 (2001): 137–83.

52. Daniel H. Newlon and Norman V. Breckner,The Oil Security System (Lexington, MA: LexingtonBooks, D. C. Heath, 1975).

53. Richard L. Gordon, “Energy Intervention AfterDesert Storm,” The Energy Journal 13, no. 3 (1992):1–15

54. Jerry Taylor and Peter Van Doren, “The Caseagainst the Strategic Petroleum Reserve,” CatoInstitute Policy Analysis no. 555, November 21,2005.

25


55. See, for example, Linda Cohen and RogerNoll, The Technology Pork Barrel (Washington:Brookings Institution, 1991). To be sure, privateinvestors can err; however, the mistakes are fewerand more readily correctable.

56. Ronald H. Coase, “The Problem of SocialCosts,” Journal of Law and Economics 3 (October,1960): 1–44. The article, a freshly written follow-up, and several other key writings appear inRonald H. Coase, The Firm, the Market and the Law(Chicago: University of Chicago Press, 1988).

57. Lewis C. Gray, “Rent under the Assumption ofExhaustibility,” Quarterly Journal of Economics 28,no. 2 (May, 1914): 466–489, reprinted in ExtractiveResources and Taxation, ed. Mason Gaffney (Madi-son, WI: University of Wisconsin Press, 1967), pp.423–46.

58. Harold Hotelling, “The Economics of Exhaust-ible Resources,” Journal of Political Economy 39, no. 2(April, 1931): 137–75. The article provided sketchesof numerous cases. It took later generations mucheffort to nail down the theory.

59. Anthony Scott, “The Theory of the Mine underConditions of Certainty,” Extractive Resources andTaxation, ed. Mason Gaffney (Madison, WI: Uni-versity of Wisconsin Press, 1967), pp. 25–62.

60. Orris C. Herfindahl, “Depletion and EconomicTheory,”Extractive Resources andTaxation, ed. MasonGaffney (Madison, WI: University of WisconsinPress, 1967), pp. 63–90.

61. Richard L. Gordon, “Conservation and theTheory of Exhaustible Resources,” Canadian Journalof Economics and Political Science, 32, no. 3 (August,1966): 319–26; Richard L. Gordon, “A Reinterpre-tation of the Pure Theory of Exhaustion,” Journal ofPolitical Economy 75, no. 3 (June, 1967): 274–86.

62.RonaldG.Cummings, “SomeExtensionsof theEconomic Theory of Exhaustible Resources,”WesternEconomic Journal 7, no. 3 (September, 1969):201–10. Cummings demonstrated that Hotelling’sgeneral case could be developed to show thathoarding had a second benefit of the present valueof the cumulative cost saving from delaying thedepletion of higher-quality resources. Many otherssubsequently independently developed the case.For instance, David Levhari and Nissan Liviatan,“Notes on Hotelling’s Economics of ExhaustibleResources,” Canadian Journal of Economics 10, no. 2(May, 1977): 177–192 shows that the moreadvanced mathematics employed by Cummingswere not needed to derive the proof. Two widelyspaced efforts showed that a discrete-time ap-proachgreatly simplified thederivations:WilliamJ.Baumol and Wallace E. Oates, The Theory of

Environmental Policy: Externalities, Public Outlays, andthe Quality of Life (Englewood Cliffs, NJ: Prentice-Hall, 1975); and Eduardo M. Modiano and JeremyF. Shapiro, “A Dynamic Optimization Model ofDepletable Resources,” The Bell Journal of Economics11, no. 1 (Spring, 1980): 212–36.

63. Numerous surveys of the literature are avail-able. Baumol and Oates’s text on environmentaleconomics included a good survey of exhaustiontheory but only in its first edition. Richard L.Gordon, An Economic Analysis of World EnergyProblems (Cambridge, MA.: MIT Press, 1981) isanother, simpler survey. Partha Dasgupta and G.M. Heal, Economic Theory and Exhaustible Resources(Cambridge: Cambridge University Press, 1979)produced the fullest review available, but it isunnecessarily complex.

64. Orris C. Herfindahl, “Depletion and EconomicTheory,”Extractive Resources andTaxation, ed. MasonGaffney (Madison, WI: University of WisconsinPress, 1967), pp. 63–90, Richard L. Gordon, “A Re-interpretation of the Pure Theory of Exhaustion,”Journal of Political Economy 75, no. 3 (June, 1967):274–86, and Tjalling C. Koopmans, “Ways of Look-ing at Future Economic Growth, Resource andEnergy Use,” Energy: Demand, Conservation, and Insti-tutional Problems, ed. Michael S. Macrakis (Cam-bridge, MA: MIT Press, 1974), pp. 3–15.

65. Hotelling’s analysis was much more complex,but also sketchier, than subsequent discussionsindicate. He presented numerous short, cryptictreatments of many different cases.

66. Hotelling, “The Economics of ExhaustibleResources,” Journal of Political Economy 39, no. 2(April, 1931): 137–75does not make this clear, butOrris C. Herfindahl, “Depletion and EconomicTheory,”Extractive Resources andTaxation, ed. MasonGaffney (Madison, WI: University of WisconsinPress, 1967), pp. 63–90.stated the conclusion andRichard L. Gordon, “A Reinterpretation of the PureTheory of Exhaustion,” Journal of Political Economy75, no. 3 (June, 1967): 274–86.proved that this hadto be the case. The simplicity of the case explains itsfrequent use, but the more general model must beused inpractice.ManyattacksonHotelling are real-ly criticisms of only considering the simplest case.

67. This is the case thatwas sketched byHotelling,which Cummings and others previously notedlater developed. Grey dealt withmovements alongthe marginal-cost curve prevailing in each timeperiod and the new cases discuss the trend towardsupply-decreasing shifts over the time representedby the curve.

68. Richard L. Gordon, An Economic Analysis ofWorld Energy Problems (Cambridge, MA: MIT

26


Press, 1981); discusses this case. With rapidlyfalling costs, prices could decline. Perpetual rapidgrowth in exhaustible resources is subject to theparadox discussed in the general literature oninvestment: it is more profitable to trade the assetthan to use it. However, in the exhaustible-resource case, where demand initially growsrapidly but then slows down, the optimal behav-ior is to start before the demand-growth slow-down and exhaust during the slow-growth peri-od. The criterion of rapidity is a growth of morethan the market rate of interest of the marginalprofitability of the optimum output at any time.

69. Those familiar with financial theory will rec-ognize that this is a less technical description ofnet present value.

70. To simplify, here I ignore the effects (notedabove) of saving high-quality resources.

71. Richard L. Gordon, “Conservation and theTheory of Exhaustible Resources,” CanadianJournal of Economics and Political Science 32, no. 3(August, 1966): 319–26.

72. The theory of interactions among firms is enor-mous. The crux is that firms would like to joinalliances to maximize profits for the group, butmany pressures preclude that outcome. Theseinclude too many participants to manage, sharpdifferences among firms, the difficulties of moni-toring performance, and the undermining of coop-eration by fears aboutwhat the others will do.Withthe popularity of game-theory approaches to inter-action, it is standard to relate the lastproblemtotheclassic and much over-cited case of the prisoners’dilemma,wherebothof two separately interrogatedprisoners are better off not to confess.However, fearthat one will confess will lead the other one to con-fess. Extensions of the theory have failed to showexperiencewill resolve this dilemma.A survey of theempirical literature is available from Margaret C.Levenstein and Valerie Y. Suslow, “WhatDetermines Cartel Success?” Journal of EconomicLiterature 44, no. 1 (March 2006): 43–95.

73. M. A. Adelman, “Mineral Depletion, with Spe-cial Reference to Petroleum,” Review of Economicsand Statistics 72, no. 1 (February, 1990): 1–10. Re-printed in M. A. Adelman, The Economics of Petrole-um Supply: Papers by M. A. Adelman 1962–1993(Cambridge, MA: MIT Press, 1993).pp. 219–39.)

74. The literature on environmentalism and itsdefects are vast. Three key critiques are GreggEasterbrook, A Moment on the Earth: The ComingAge of Environmental Optimism (New York: Viking,1995); Julian L. Simon, The Ultimate Resource: 2,(Princeton, NJ: Princeton University Press 1996);and Bjørn Lomborg, The Skeptical Environmentalist:

Measuring theReal State of theWorld (Cambridge andNew York: The Cambridge University Press,2001). Easterbrook, an environmental journalist,provides surveys of numerous key issues. Hisexposition suffers badly from his discomfort overthe anti-intervention implications of his reviews.Simon presents a broad attack on all forms ofresource pessimism. Lomborg’s work presents aconfirmation of Simon’s views, which Lomborgwas seeking to refute. The environmentalistattacks on these works are illustrations of the ten-dency to excess rather than careful refutations.

75. It is indicative of the state of the situation thatno obvious citations arise on either side. Whennuclear power was a hot topic, concerns aroseabout release of radiation from regular opera-tions, large discharges from accidents, diversionof nuclear material to military programs or to ter-rorists, and the hazards of waste disposal. As allbut the last were deflated by experience, waste dis-posal became the sole concern. Critics demandedan instant solution and then opposed efforts todevelop such a remedy.

76. U. S. Congress, Office of Technology Assess-ment, Acid Rain and Transported Air Pollutants:Implications for Public Policy (Washington: Govern-ment Printing Office, 1984).

77. Patrick J. Michaels, Meltdown, The PredictableDistortion of Global Warming by Scientists, Politicians,and the Media (Washington: Cato Institute, 2004),and also his shorter writings, which provide amoderate review of why the reaction to globalwarming is overdone.

78. Indur M. Goklany, The Improving State of theWorld: Why We’re Living Longer, Healthier, MoreComfortable Lives on a Cleaner Planet (Washington:Cato Institute, 2007); “What to Do about ClimateChange,” Cato Institute Policy Analysis no. 609,February 5, 2008.

79. These efforts and their refutation have reachedthe point where a new anthology has appeared:Tyler Cowen and Eric Crampton, eds. MarketFailure or Success: The New Debate (Cheltenham andNorthampton, UK: Edgar Elgar for the Indepen-dent Institute, 2003). This is a sequel to Cowen’sThe Theory of Market Failure: A Critical Examination(Fairfax, VA:GeorgeMasonUniversity Press, 1988),which deals with the older theories. Both antholo-gies start with examples of the assertions of failureand go on to present articles criticizing the claims.Curiously, while numerous books review the stateof theory after the newer theories, no similar uni-fied treatment of only the case against the oldertheories seems to exist.

80. Daniel F. Spulber, Regulation and Markets

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(Cambridge MA: MIT Press, 1989). Spulber offersan analysis of what he calls “internalities” to relatethese theories to the persistence of government reg-ulation of private transactions. Spulber’s analysis isextended—but not cited—in Glen Whitman,“Against the New Paternalism: Internalities and theEconomics of Self-Control,” Cato Institute PolicyAnalysis no. 563, February22, 2006.Whitmandealswith a family of arguments for intervention whenthe individual can be expected to make a decisionthat is subsequently regretted—such as to smoke orto not save enough money for retirement. Thesearguments lack theanalyticbasisof those treatedbySpulber; despite its proponents’ claim of novelty,the approach ismerely a repackagingof the familiarold argument that superioroutsiders exist, and thatthey can act efficiently to correct the errors of indi-viduals. What makes Spulber more germane thananything else in the vast literature that grappleswith asymmetric-information theory is his explicitconsideration of the internality question.

81. George A. Akerlof, “The Market for ‘Lemons’:Qualitative Uncertainty and the Market Mechan-ism,” Quarterly Journal of Economics 84 (1970):488–500.

82. Eric W. Bond, “A Direct Test of the ‘Lemons’Model: The Market for Used Pickup Trucks,”American Economic Review 72, no. 4 (September,1982): 836–40. The Akerlof article, which helpedwin a Nobel Prize in economics for its author, isone of the four examples of the new theory ofmarket failure reprinted in Cowan and Crampton(the refuting essay was the just-cited paper fromBond). Two of the remaining three examples werefrom Joseph E. Stiglitz, who has generated manymodels of peculiarly inefficient markets. The oth-er comes from Paul A. David. The Nobel prizesawarded to Akerlof and Stiglitz for their work inthis area prove that novelty, not validity, cansecure academic acclaim.

83. The chief offenders are a research group atOak Ridge National Laboratories and AmoryLovins.

84. Paul L. Joskow and Donald B. Marron, “WhatDoes a Negawatt Really Cost? Evidence fromUtility Conservation Programs,” The Energy Journal13, no. 4 (1992): 41–71.

85. One of the rarer economic defenses of CAFEstandards can be found in David Greene, “WhyCAFE Worked,” Energy Policy 26, no. 8 (1998):595–614. Greene argues, contrary to what isargued here, that exactly the right combination ofmarket failures prevail to justify mandatory fuel-efficiency standards.

86. Robert W. Crandall and John G. Graham, “The

Effects of Fuel Economy Standards on AutomobileSafety,” Journal of Law and Economics 38, no. 1 (April1989): 97–118.

87. Andrew N. Kleit, “Impacts of Long-RangeIncreases in the Corporate Average Fuel Economy(CAFE) Standard,” Economic Inquiry 42 (2004):279–94.

88. Carolyn Fischer, Winston Harrington, and IanW .H. Parry, “Should Automobile Fuel EconomyStandards Be Tightened?” Energy Journal 28, no. 4(2007): 1–29.

89. Among the reports published in the 1970s areJoseph P. Mulholland, Economic Structure and Behav-ior in theNatural Gas Production Industry, Staff Report tothe Federal Trade Commission (Washington: Govern-ment Printing Office, 1979); Joseph P. Mulholland,John Haring, and Stephen Martin, Staff Report on anAnalysis of Competitive Structure in the Uranium SupplyIndustry (Washington: Government Printing Office,1979); U.S. Congress, General Accounting Office,The State of Competition in the Coal Industry (Washing-ton: 1977); U.S. Department of Energy, CoalCompetition: Prospects for the 1980s (Springfield: VA :National Technical Information Service, 1981); U.S.Federal Trade Commission, Bureau of Economics,Report to theFederalTradeCommission on the Structure ofthe Nation’s Coal Industry 1964–1974 (Washington:Government Printing Office, 1978). Later studiesinclude JayS.Creswell Jr., ScottM.Harvey, andLouisSilvia,Mergers in theU.S.PetroleumIndustry1971–1984:An Updated Comparative Analysis (Washington: U.S.Federal Trade Commission, 1989); U.S. FederalTradeCommission,BureauofEconomics,ThePetro-leum Industry: Mergers, Structural Change, and AntitrustEnforcement (Washington: 2004); U.S. Federal TradeCommission, Gasoline Price Changes: The Dynamic ofSupply,Demand, andCompetition (Washington: 2005);U.S. Federal Trade Commission, Investigation ofGasoline Price Manipulation and Post-Katrina GasolinePrice Increases (Washington: 2006); U.S. GeneralAccounting Office, Energy Markets: Effects of MergersandMarket Concentration in the U.S. Petroleum Industry(Washington: 2004).

90. This differs from the complex market-failuretheories criticized above that rely on policy alter-natives that are inapplicable to internationaltrade.

91. Jagdish N. Bhagwati, “The Theory of PoliticalEconomy, Economic Policy, and Foreign Invest-ment,” in Public Policy and Economic Development,M. Scott and S. Lai, eds. (Oxford, UK: ClarendonPress, 1990), pp. 217–30, reprinted in JagdishBhagwati, Political Economy and InternationalEconomics, Douglas A. Irving, ed. (Cambridge, MA:MIT Press, 1991), pp. 154–67. The emphasis is inthe original.

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92. Ronald H. Coase, “The Problem of SocialCost,” Journal of Law and Economics 3 (October1960): 1–44. An alternative critique is Buchanan’sthought-provoking presentation about the rele-vance of the “club goods.” Buchanan suggestedthat private clubs served as a way for a group col-lectively to consume a good. Thus, it may well bethat, in many circumstances, private-club actionmay be preferable to government action. James M.Buchanan, “An Economic Theory of Clubs,”Economica 32 (February, 1965): 1–14. His treat-ment concentrates on the formal analysis of clubsrather than the implications of government inter-vention. The Coase article on lighthouses (dis-cussed below)more clearly expressed concern overneglect of the club alternative.

93. William J. Baumol and Wallace E. Oates, TheTheory of Environmental Policy: Externalities, PublicOutlays, and the Quality of Life (Englewood Cliffs, NJ:Prentice-Hall, 1975) and the revised edition(Cambridge: Cambridge University Press, 1988)suggest, but do not clearly express or resolve thisproblem. The key point is that the correct margin-al charge or subsidy is not sufficient to ensure thatonly socially profitable firms survive. This require-ment necessitates lowering unregulated profits bythe total cost of external costs. Standard economicprinciples show the problems. It is clearest with asimple flat subsidy. It would raise the profits ofexisting and entering firms and thus offset themarginal incentives topollutioncontrol, unless thesubsidy to a socially inefficient firm was maxi-mized at zero output. A tax by reducing total prof-its encourages exit, but a flat tax could lower prof-its by more than the total cost of externalities. Inthe standard case of marginal costs that increasewith the level of polluting activity, a flat tax equalto the marginal cost of the optimal level of the pol-luting activity would lower profits by more thanthe total cost of externalities. The total cost wouldbe the area under the marginal cost curve, which isless than the tax charge equal by definition to themarginal cost times the level of polluting activity.More complex policies could in theory remedythese defects.

94. The controversial nature of Coase’s arguments,and the rambling way in which he presented them,producedmuch commentary that differs consider-ably in the interpretation of his work. My interpre-tation can be restated by arguing that Coase showsthat, in practice, transaction costs can range fromones so low that private solutions are feasible, toones so high that any response is inefficient. GlennFox, “The Real Coase Theorem,” The Cato Journal27, no. 3, (Fall 2007): 373–96, echoes Coase’s 1988comments by stressing that consideration of trans-action costs is the essence ofCoase’s analysis. Fox iscorrect in that others have stressed cases where pri-vate solutions were possible and neglected the

much briefer, but still complete, discussion of theproblems caused by high transaction costs. Fox,however, seems to have gone too far and neglectedthe large number of cases in which transactioncosts are low enough to allow private solutions.

95. Ronald H. Coase, “The Lighthouse in Econom-ics,” Journal of LawandEconomics 17, no. 2 (October,1974): 357–76; also in Ronald H. Coase, The Firm,the Market and the Law (Chicago: University ofChicago Press, 1988).

96. George J. Stigler, The Citizen and the State: Essayson Regulation (Chicago: University of ChicagoPress, 1975).

97. Paul A. Samuelson, “The Pure Theory of PublicExpenditure,” Review of Economics and Statistics 36,no. 4 (November, 1954): 387–89. Reprinted inJoseph E. Stiglitz, ed., The Collected Papers of Paul A.Samuelson, vol. 2 (Cambridge, MA.: The MIT Press,1966), pp. 1223–25. The difficulties of that articlerequired several follow-ups: Paul A. Samuelson,“Diagrammatic Exposition of a Theory of PublicExpenditure,” Review of Economics and Statistics 37,no. 4 (November, 1955): 350–56. Reprinted inJoseph E. Stiglitz, ed., The Collected Scientific Papers ofPaul A. Samuelson, vol. 2 (Cambridge, MA.: The MITPress, 1966), pp. 1226–32. Paul A. Samuelson,“Aspects of Public Expenditure Theories,” Review ofEconomics and Statistics 40, no. 4 (November, 1958):332–38. Reprinted in Joseph E. Stiglitz, ed., TheCollected Scientific Papers of Paul A. Samuelson, vol. 2(Cambridge, MA.: The MIT Press, 1966), pp.1233–39. Paul A. Samuelson, “Pure Theory ofPublic Expenditures and Taxation,” in Public Eco-nomics, eds. J. Margolis and H. Guitton (New York:St. Martins Press, 1969), pp. 98–123. Reprinted inRobertC.Merton, ed.,CollectedScientificPapersofPaulA. Samuelson, vol. 3, (Cambridge, MA.: The MITPress, 1972), pp. 492–517. Samuelson stressed hewas formalizingconcepts thathadbeenmore loose-ly discussed in prior writings, and that he was treat-ing an extreme case.

98. The argument that the provision of publicgoods is the only valid role of government reliesupon recognizing that everything governmentdoes supplies a service to its citizens, and that cit-izens are the best judges of the value of those ser-vices.

99. This is particularly true of theworks devoted topublic choice. They are strongest in treating thetendency to inefficient policies. However, suchtreatments also have had major contributionsfrom economists who do not specialize in publicchoice. The public-choice literature is weak on theproblemsof identifyingandsatisfyingdemands forpublic goods. This literature is surveyed in DennisC.Mueller,PublicChoice III (Cambridge: Cambridge

29


University Press, 2003). The Liberty Fund hasissuedmultivolume collections of theworks of twoleadingpublic-choice economists, JamesBuchananand Gordon Tullock.

100. Joseph A. Schumpeter, Capitalism, Socialism,and Democracy, 3rd ed., (New York: Harper &Brothers, 1950).

101. The germane literature on this matter is vast.For important contributions, see Anthony Downs,An Economic Theory of Democracy (New York: Harperand Row, 1957); Gordon Tullock, “The WelfareCosts of Tariffs, Monopolies and Theft,” WesternEconomic Journal 5 (1967): 224–32; Anne O. Krueger,“The Political Economy of the Rent-Seeking Soci-ety,”AmericanEconomicReview64, no. 3 (June, 1974):291–303; Jagdish N. Bhagwati, “Directly-Unpro-ductive Profit-Seeking (DUP) Activities,” Journal ofPolitical Economy 90:5 (October, 1982): 988–1002;George J. Stigler, “The Theory of Economic Regu-lation,” Bell Journal of Economics and ManagementScience 2, no. 1 (Spring, 1971): 3–21; and SamPeltzman, “Towards a More General Theory ofRegulation,” The Journal of Law and Economics 19, no.2 (August, 1976): 211–40.

102. See for example, Joseph P. Kalt and Mark A.Zupan, “Capture and Ideology in the EconomicTheory of Politics,” American Economic Review 74,no. 3 (June, 1984): 279–300.

103. I have a cherished personal example of this.When I served on the Interior Department’s coalleasing commission in 1985–86, MassachusettsDemocratic Congressman Edward Markey pre-sented an argument for vigorous enforcement ofthe coal-leasing amendments. I asked him whetherhe would continue to do so if he realized that thishurt his constituents. He expressed doubts andfled before I could show him that he was clearlywrong. The kind of enforcement that he proposedwas likely toproduce inefficiently low leasing levels.The amendments mandated higher royalty levels.Both effects reduce supply and thus raise prices toconsumers. Massachusetts, of course, consumesbut does not produce coal.

104. Themost celebrated of his several statementson the limited abilities of government is RonaldH. Coase, “The Problem of Social Cost,” Journal ofLaw and Economics 3 (October, 1960): 1–44.

105. Mises wrote extensively on the defects ofintervention and the virtues of free markets.Ludwig von Mises, Human Action: A Treatise onEconomics, 4th rev. ed. (Indianapolis, IN: LibertyFund, 2007 [1949, 1966, 1996]); Percy L. GreavesJr.,MisesMade Easier: A Glossary to Ludwig vonMises’Human Action, presents both sides of the case;Ludwig von Mises, Socialism: An Economic and

Sociological Analysis (Indianapolis: Liberty Classics,1981) is a sweeping critique of intervention thatwas his earliest comprehensive attack on social-ism.

106. Oscar Lange, “On the Economic Theory ofSocialism,” Review of Economic Studies 4:53–71 and4:123–42 (1936–1937).

107.Hayek’smost famous takeon this isFriedrichA.Hayek, “TheUsesofKnowledge inSociety,”AmericanEconomicReview35, no. 4 (September, 1945): 519–30.Two complementary articles deserve note. FriedrichA. Hayek, “The New Confusion about ‘Planning’,”Morgan Guaranty Survey (January, 1976): 4–13. Re-printed in Friedrich A. Hayek, New Studies inPhilosophy, Politics Economics and the History of Ideas(Chicago, IL.: University of Chicago Press, 1978).Friedrich A. Hayek, “The Pretense of Knowledge,”AmericanEconomicReview79:6(December,1974):3–7.

108. James M. Buchanan and Gordon Tullock, TheCalculus of Consent: Logical Foundation ofConstitutionalDemocracy is a critical example (Ann Arbor, MI:University of Michigan Press, 1962). (Volume 3 ofthe Liberty Fund Collected Works of Buchananand volume 2 of the selected works of Tullock.)They start with Wicksell’s suggestion to requireunanimous agreement for state intervention. Atleast tacitly, they conclude that the unmanageablyhigh transaction costs of reaching a unanimoussolution require resort to alternatives. Rather thanconfront the daunting task of defining an optimalalternative, Buchanan and Tullock simply indicatethe drawbacks of other approaches such as simplemajority voting. A fundamental flaw of this analy-sis is that it presumes far more citizen input thanarises. In practice, we citizens only get to choose afew participants in the decision process. Thosedecisionmakers have great latitude in determiningwhat todo.Undertaking exhaustive studiesofpub-lic demand is not a widely used option. Thisreliance on instinct should be another major rea-son for skepticism about the extension of govern-ment activities. The demand-revealing approachsubsequently endorsed by Tullock has the samedrawbacks. See Dennis C. Mueller, Public Choice III,(Cambridge: Cambridge University Press, 2003):pp. 162–68, for an uncritical review of the conceptand its history.

109. Richard A. Posner, “Natural Monopoly and ItsRegulation,” Stanford Law Review 21 (February,1969): 548–643. (ReprintedbyTheCato Institute in1999 with a new introduction by Posner.) Even thisessay,which isoften representedas a radical critiqueof state intervention,understates the trueproblems.Efficient public-utility regulation would seek toimpose efficient prices that eliminate monopolyprofits. Suchprices are difficult todesign.To aggra-vatematters, an infinite number of efficient pricing

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schedules exist. Efficient pricing involves sellingmarginal sales at the marginal cost of productionand alleviating the central problem with a decreas-ing cost industry. If prices on all outputs equalmar-ginal costs, total costs exceed revenues. In response,higher charges for some inframarginal purchasesare the solution. Thus, there is the telephoneapproach of an entry fee to allow unlimited pur-chase at themarginal cost of efficient output or theelectric-power approach of declining block rateswhen earlier units of consumption are priced high-er than later ones. In either case, given a goal of pre-

venting monopoly profits, the required profit cutscan be made in infinitely many ways. The total cutis fixed, but any amount of anything can be split ininfinitely many ways. Consider the case of ten con-sumers sharing a $10 cut. Possibilities such as $10toone consumer andnothing to the rest; $1 to eachconsumer; and$2 each to five consumers andnoth-ing to the other five, are all among the infinite pos-sibilities. Richard L. Gordon, “Don’t RestructureElectricity: Deregulate,” Cato Journal 20, no. 3(Winter, 2001): 327–58.

STUDIES IN THE POLICY ANALYSIS SERIES

627. A Federal Renewable Electricity Requirement: What’s Not to Like?by Robert J. Michaels (November 13, 2008)

626. The Durable Internet: Preserving Network Neutrality withoutRegulation by Timothy B. Lee (November 12, 2008)

625. High-Speed Rail: The Wrong Road for America by Randal O’Toole(October 31, 2008)

624. Fiscal Policy Report Card on America’s Governors: 2008 by Chris Edwards(October 20, 2008)

623. Two Kinds of Change: Comparing the Candidates on Foreign Policyby Justin Logan (October 14, 2008)

622. A Critique of the National Popular Vote Plan for Electing the Presidentby John Samples (October 13, 2008)

621. Medical Licensing: An Obstacle to Affordable, Quality Care by ShirleySvorny (September 17, 2008)

620. Markets vs. Monopolies in Education: A Global Review of the Evidenceby Andrew J. Coulson (September 10, 2008)

619. Executive Pay: Regulation vs. Market Competition by Ira T. Kay and StevenVan Putten (September 10, 2008)

618. The Fiscal Impact of a Large-Scale Education Tax Credit Program byAndrew J. Coulson with a Technical Appendix by Anca M. Cotet (July 1, 2008)

617. Roadmap to Gridlock: The Failure of Long-Range MetropolitanTransportation Planning by Randal O’Toole (May 27, 2008)


PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2 2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM

616. Dismal Science: The Shortcomings of U.S. School Choice Research andHow to Address Them by John Merrifield (April 16, 2008)

615. Does Rail Transit Save Energy or Reduce Greenhouse Gas Emissions? byRandal O’Toole (April 14, 2008)

614. Organ Sales and Moral Travails: Lessons from the Living Kidney VendorProgram in Iran by Benjamin E. Hippen (March 20, 2008)

613. The Grass Is Not Always Greener: A Look at National Health CareSystems Around the World by Michael Tanner (March 18, 2008)

612. Electronic Employment Eligibility Verification: Franz Kafka’s Solutionto Illegal Immigration by Jim Harper (March 5, 2008)

611. Parting with Illusions: Developing a Realistic Approach to Relationswith Russia by Nikolas Gvosdev (February 29, 2008)

610. Learning the Right Lessons from Iraq by Benjamin H. Friedman,Harvey M. Sapolsky, and Christopher Preble (February 13, 2008)

609. What to Do about Climate Change by Indur M. Goklany (February 5, 2008)

608. Cracks in the Foundation: NATO’s New Troubles by Stanley Kober(January 15, 2008)

607. The Connection between Wage Growth and Social Security’s FinancialCondition by Jagadeesh Gokhale (December 10, 2007)

606. The Planning Tax: The Case against Regional Growth-ManagementPlanning by Randal O’Toole (December 6, 2007)

605. The Public Education Tax Credit by Adam B. Schaeffer (December 5, 2007)

604. A Gift of Life Deserves Compensation: How to Increase Living KidneyDonation with Realistic Incentives by Arthur J. Matas (November 7, 2007)

603. What Can the United States Learn from the Nordic Model? by Daniel J.Mitchell (November 5, 2007)

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