July 03, 2008

Costly Oil: The Return of Stagflation?

After the American Century

Today the European Bank is widely expected to raise interest rates. The mantra of economists remains that inflation must be controlled through higher rates. In "normal times" this seems to be the case. Raising interest rates makes money a bit more expensive, curbing consumer spending, slowly down the economy. The usual metaphor is that the economy is "overheated," like an engine pushed too hard. But "normal times" are those when the cost of raw materials remain reasonably stable, especially the cost of oil, coal, and other fuels.

Back in the 1970s the American Federal Reserve kept raising interest rates, because of inflation. But the remedy did not cure, because the cause of inflation was higher energy prices. What resulted was absurd. The interest rates went up to almost 20% to combat inflation while the economy stagnated. The pundits called this "stagflation" and we may be about to see the same thing happen again.

As of this morning, the price of oil has reached $145 a barrel. In the United States and in Europe consumers have been protesting, to no effect, because they are complaining to their national governments. But in a globalized economy, no prime minister can control the price, except by lowering gasoline taxes. This would stimulate consumption, however, and be bad for the balance of trade in an oil-importing country. Nor will raising interest rates lower the cost of oil, except marginally, by reducing economic activity.

Wise leaders - unlike George W. Bush - might respond to this new situation in the following way.

(1) Tax vehicles not by weight but according to how much oil they use, i.e. very low taxes for the most efficient vehicles and punitive taxes for those that are not.

(2) Halt road-building and invest the same money in public transit.

(3) Permit some rezoning of cities, so that population density can be increased. Deconcentration of American cities, which began in the 1920s and 1930s, has created a sprawling energy-inefficient economy, making it harder for mass transit. Rezoning might be modeled on the fine exampleof the Dutch.

(4) Give tax-incentives to energy conservation of all types, including building insulation, heat-pumps, and better architectural design.

(5) Restructure utility prices so that there is a financial reward to the companies that reduce consumer demand.

(6) Invest in alternative energy R & D and in its installation.

These are not new ideas. They are the ideas which most governments have ignored, in practice, for the last two decades.

The current high prices signal the need for a new energy regime. This is not just another economic storm that can be survived by raising interest rates.

If you want to know a bit more about the history of US energy consumption, see
David E. Nye, Consuming Power: A Social History of American Energies (MIT Press).