PREPARED STATEMENT OF ROBERT C. FRY, JR., AND R. GLENN HUBBARD

THE ECONOMIC ADVANTAGES OF THE BRADLEY-PERCY PROPOSAL

OVER ALTERNATIVE POLICY RESPONSES TO

OIL SUPPLY INTERRUPTIONS

We would like to take this opportunity to present some qualitative and empirical support for the Bradley-Percy proposal (S.1354) to use market pricing of oil during a disruption in conjunction with the implementation of a revenue-recycling scheme to address the equity aspects of the problems caused by oil supply disruptions. We find that a proposal like S.1354 is likely to better serve the national economic interest in the event of a large oil supply interruption than would alternatives of "doing nothing" or controlling oil prices.

The venerable phrase "ceteris paribus" dots the musings of economists, though other things are seldom equal. Much of the policy analysis done by economists has focussed on static experiments in which variables such as oil prices were considered exogenous to the economy; feedback effects and interdependence among markets have been ignored. In truth, policies frequently do not work as planned, because we often ignore some of the channels through which the policies may affect the economy.

output.

One lesson which we have learned the hard way is that our economy is very sensitive to changes in oil prices. Increases in the price of oil directly and immediately affect the general price level. They also divert spending from home-produced goods to imports, increasing the wealth transfer to oil producing countries and reducing the aggregate demand for U.S. Domestically, there is a transfer of income from consumers of oil to producers of oil. The rise in the relative price of oil, an important input, reduces the profit-maximizing level of output for firms which use oil, necessitating a fall in real GNP from the supply side. This reduction in output reduces the demand for other inputs, such as labor and capital. These direct aggregate demand and supply effects are magnified because our economic system is not perfectly flexible. Because of rigidities in

the economy, particularly rigid nominal wages, unemployment of resources will result, and the economy will fail to attain its (already diminished) consumption and production possibilities. The failure of wages and prices to adjust downward aggravates and renders permanent the rise in the price level caused by an oil price increase. The ultimate consequences for inflation and GNP will depend on the magnitude and timing of the oil price increase, on the effect of the consequent price level increase on wage settlements, and on the fiscal, monetary, and regulatory responses of the

government. All of these linkages are discussed in detail in Hubbard and Fry, "The Macroeconomic Impacts of Oil Supply Disruptions."

Given the economic costs of oil supply interruptions, we are faced with three policy choices: (1) do nothing; (2) impose price and allocation controls; or (3) let the market price oil while using the fiscal (tax and spending) system to address the equity imbalances occasioned by the disruption.

DO-NOTHING ALTERNATIVE

To "do nothing" does not imply a neutral effect of government policy on the economy. Windfall profit tax revenues would balloon during a large oil supply disruption, causing a substantial fiscal drag on the economy. An oil supply disruption during 1982 which raises the world price of oil by 30 percent would raise windfall profit tax revenues in 1982 to nearly $34 billion, roughly $13 billion more than the current estimate by the Congressional Budget Office of windfall profit tax revenue for 1982.

APPROACH OF CRUDE OIL PRICE CONTROLS

With large oil price increases yielding such a devastating effect on the economy, the political temptation to control domestic crude oil prices has been overwhelming. Though oil price controls have been rejected by the vast majority of economists, the expiration of the old Emergency Petroleum Allocation Act of 1973 (EPAA) has led to new attempts to extend the authority to impose price and allocation controls (for example, S1503). Proponents of crude oil price controls argue that controls help to insulate the economy from the effects of oil price shocks by lowering the average price of a barrel of oil and by preventing holders of domestic oil reserves from reaping a windfall from a foreign price increase. Inflation

should be lower and real incomes higher under oil price controls than they would be without tnem, they maintain. Concomitant allocation controls are

justified on the basis that certain groups in society have special needs

for oil.

There are many problems with the maintenance of price allocation

controls.

Domestic Supply. Opponents of controls have often countered that the cap inhibits the economic viability of looking for and producing more oil. If controls were lifted, the increased supply of oil would help to lower the oil price. It is likely, though, (as we will later discuss) that even if supply is completely unresponsive to the price of oil, controls may fail to accomplish their purpose. Indeed, the controls may have cost us dearly in the past.

An excellent survey of the economics of crude oil price regulation can be found in Kalt, The Economics and Politics of Oil Price Regulation, PP. 69-102. Kalt concludes that the impact of price controls on the time path of extraction from existing oil reserves is a priori ambiguous, but that price controls unambiguously discourage exploration and development of new supply sources.

Distortion of Investment.

EPAA-like systems of price controls on

domestically produced crude oil illustrate the government's ability to reduce private investment in particular industries by regulation as well as to distort the distribution of available supplies. Since petroleum and natural gas are among the most capital-intensive industries in the United States, the aggregate demand for capital may be reduced through the imposition of price controls as investment is diverted to less capital-intensive sectors. Since crude oil prices were decontrolled, there has been a dramatic increase

in investment in the oil industry.

Demand-side Effects. The most potent of the effects of oil price controls on the economy occur on the demand side. The U.S. is a major consumer of oil, consuming its own domestic production of 8.6 million barrels of oil per day and importing another 5.2 million barrels of oil per day. As long as the marginal barrel of oil is imported, changes in U.S. oil demand, whether from changes in domestic economic performance or from changes in the price of oil faced by U.S. consumers, can have a significant impact on world oil prices. For a more detailed discussion of links between the U.S. economy and the world oil market, see Hubbard and Fry, "The Macroeconomic Impacts of Oil Supply Disruptions.

Under domestic price controls, the average price of oil is a weighted average of a lower controlled price and a higher "world" price. The lower average price faced by U.S. buyers of oil and oil products stimulates U.S. oil demand and U.S. oil imports, putting upward pressure on the world price of oil. The resulting increased oil import bill reduces GNP. Though the price controls may restrain inflation in the short run, in the long run they may increase inflation because of the higher world oil price. To the extent that there is a positive domestic supply response to decontrolling oil, the case against price controls becomes stronger.

To mitigate the short run effects of an oil supply interruption, we need substantial stocks of oil inventories. Yet price controls discourage private stockpiling. As firms optimally plan their level of inventories, we know that the higher is the expected price next period (relative to that today), the higher will be the inventory levels (since profits are made on increasingly valuable inventories). Price controls lower the path of expected future prices as seen by the firm. Hence, the existence of price