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Monday, March 2, 2009

Unintended Consequences in Energy Policy

Costly Policies Have Reduced Economic Freedom and Ended Lives

On the first day of every economics class I teach I start with The Ten Pillars of Economic Wisdom. This is a list I have put together of the ten most important principles in economics. Pillar number six is, “Every action has unintended consequences; you can never do only one thing.” U.S. energy policy illustrates this to tragic effect. Costly policies that have reduced economic freedom and had nasty economic consequences riddle the landscape.

Start with the Corporate Average Fuel Economy (CAFE) law, which requires each auto producer in the U.S. market to make fleets that average at least 27.5 miles per gallon for cars and at least 20.7 mpg for trucks. (Former President Bush and Congress increased that to 35 mpg by 2020, with no lower standard for light trucks.) That law had the unintended but totally predictable consequence of making cars less safe. The reason is that one relatively cheap way to raise fuel economy is to make cars lighter, and the lighter they are, other things being equal, the more dangerous they are to their occupants. In 1989 two economists, Robert Crandall of the Brookings Institution and John Graham of Harvard University’s John F. Kennedy School, found that, adjusting for the downsizing of cars that would have occurred anyway, the CAFE laws would cause an extra 2,200 to 3,900 deaths over the life of a 1989-model-year car.

But the CAFE law is itself the result of another unintended consequence of government policy, namely price controls on oil and gasoline. President Nixon’s economy-wide wage and price controls, imposed in 1971, did not cause much difficulty at first. But when the Organization of Petroleum Exporting Countries (OPEC) raised the world price of oil from about $3 a barrel to about $11 over a few months in late 1973, Nixon’s price controllers refused to allow refiners to pass on the whole increase in the price of gasoline. The result was a massive shortage of gasoline, with long lines at the pump. Rather than remove the controls, Nixon had government officials start allocating the gasoline by various arbitrary criteria, a process the Ford and Carter administrations continued.

Government officials in the Ford administration and in Congress noticed that American car buyers were not buying as many high-fuel-economy cars as these officials thought they should. In other words, Americans were responding to the artificially low price of gasoline by acting as if the price of gasoline were low! Gee, what a surprise. Of course, instead of removing the price controls, Congress and Ford decided to regulate the fuel economy of new cars—that’s how we got CAFE. Like all regulations, this one bred its own lobby, featuring Ralph Nader and Clarence Ditlow. They had been, until that time, advocates of car safety. But they wanted enforced fuel economy even more.

That’s not the end. One way the companies could meet their CAFE targets was by importing small, high-fuel-economy cars from their foreign production facilities. The United Auto Workers union noticed this and lobbied for—and achieved—separate standards. Auto companies then had to hit the standard with their domestic production and, separately, with their imports. That caused the companies to produce more small cars at home rather than import even successful cars from abroad. According to William Niskanen, the chief economist at Ford in the late 1970s, Ford dropped its Fiesta in the late 1970s not despite, but because of, the car’s potentially large market: Ford feared that its German-made Fiesta would “steal” sales from its U.S.-made Escort, thus lowering its domestic CAFE average.

Moreover, even the increase in the world price of oil engineered by OPEC in late 1973 was in part the unintended consequence of U.S. energy policy. Why? Because OPEC had been formed in response to President Eisenhower’s restrictions on oil imports. As economist Ben Zycher points out, in 1959 the U.S. government established the Mandatory Oil Import Quota Program (MOIP), which restricted the amount of imported crude oil and refined products allowed into the United States. It also gave preferential treatment to oil imports from Canada and Mexico. Two major growing sources of supply at the time were the Middle East and Venezuela. By reducing a major market for Middle Eastern and Venezuelan oil, the import-quota system drove down the demand for that oil, causing its price to fall in February 1959 and again in August 1960.

In September 1960 governments of four Persian Gulf countries—Iran, Iraq, Kuwait, and Saudi Arabia—facing discrimination against their oil, joined with Venezuela to form OPEC. Their goal was to get monopoly power to offset the monopsony power created by the U.S. oil import quota system and thus get higher prices. Although OPEC was at first relatively powerless, by 1973 the governments of eight other countries—Algeria, Ecuador, Gabon, Indonesia, Libya, Nigeria, Qatar, and the United Arab Emirates—had joined. In 1973, OPEC made its move.

From the CAFE to the Mess Tent

CAFE laws and other fuel-economy standards are not the only unintended consequences of U.S. price controls on oil and gasoline. One can even speculate reasonably that these price controls led to two major wars initiated by the U.S. government. The reason is that instead of blaming their government for lines at gas stations, Americans have tended to blame foreign governments—especially the government of Saudi Arabia, the leader of the OPEC cartel and its largest producer. In 1979 President Carter formed the Rapid Deployment Force to train for combat mainly in deserts. President Reagan kept this force and renamed it the U.S. Central Command.

Whatever Carter’s motives or understanding in forming this force, the hardwiring in Americans’ minds led them to associate gas lines with nasty Middle East governments rather than with the nasty U.S. government. That made them more willing than otherwise to support intervention in Middle Eastern affairs to secure the continued flow of oil. Thus when Henry Kissinger claimed in August 1990 that Saddam Hussein’s invasion of Kuwait, if left unopposed, “would cause a world-wide economic crisis,” many Americans believed him. In a Wall Street Journal article that month, I showed that, in fact, the absolute worst harm Hussein could do to the U.S. economy, even if he grabbed Saudi Arabia and the United Arab Emirates, was a loss of less than half of 1 percent of GDP annually. But because so many Americans feared the return of gas lines, they were more open than otherwise to a U.S. attack on Iraq.

Later, in 2003, the U.S. government still had the military capability to invade Iraq. The stated issue this time was Saddam Hussein’s alleged weapons of mass destruction. Still, the fact that the U.S. government had the capability to attack Iraq was due in part to Carter’s buildup of the Rapid Deployment Force.

As poet Robert Burns might say, “Oh what a tangled—and tragic—web government weaves when first it practices to intervene.”