If a household — or country — spends more on gasoline because prices rise, then it usually must spend less on something else. That is a hard fact of life. It is better to face the tradeoff squarely, however, than to pretend it does not exist.
Countries that accepted reality when oil prices rose sharply in the 1970s, such as Japan, weathered the storm with remarkably little damage. Those that stayed in denial, such as the United States, only prolonged their economic agony.
Any household has given levels of income and wealth. If the price of some necessity, such as gasoline, increases, the family can do one of several things:
• Reduce the quantity of gas it buys so that the total amount spent on gas stays the same.
• Keep buying the same quantity of gasoline without increasing total household spending by reducing purchases of other things such as clothing, recreation or housing.
• Continue buying the same quantities of fuel and other things by saving less.
• If savings are already low, finance continued levels of consumption by eating into savings. Because many households have limited net worth, this option usually is limited in time.
Most households react to higher oil prices with some combination of the above. That is, they try to use less fuel, they reduce spending on less important items and they may dip into their savings.
Higher fuel prices change other tradeoffs. With gas at $2.20, an SUV’s roominess and comfort is less compelling than when it costs $1.20. Higher heating bills make insulation and better windows more attractive. Flying home for the holidays may be cheaper than driving.
A nation faces similar tradeoffs. If it has to send more money abroad to pay for imported oil, then it must either export more of other goods or borrow more from other countries.
If it shuns imported crude, it must devote more resources to producing domestic fuels or alternatives such as ethanol, electric autos or mass transit. Resources switched to producing such alternatives must be taken from existing uses. As economists say, “there is no such thing as a free tank of gas.”
The good news is that markets work remarkably well in such resource re-reallocation. Back in the 1970s, the Carter administration erred by shunning the market. It thought wise engineers — such as Carter — should determine adjustments to higher crude prices. Natural gas prices remained regulated. Federal money poured into synthetic crude plants that now stand idle.
Japan, in contrast, let higher world energy prices pass on to households and businesses. Households and businesses adjusted, and the Japanese economy suffered much less from the 1974 and 1979 price shocks than did the United States.
The U.S. economy is highly resilient. The amount of energy needed to produce a given amount of output is much lower than during previous oil shocks. Over the long run, we can live with oil at $60 a barrel or even higher. We just need to trust market forces to determine how our economy adjusts.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.