What choices need to be made among industries if we are to keep the effects of shortages from snowballing into a major recession?

If there is a risk of a significant economic slowdown in 1974, what are the economic policies we should adopt now to ease the adjustment and to minimize economic dislocation?

Last summer we were already faced with the prospect of serious fuel oil shortages. The Arab oil embargo has made the situation critical, but it has also given the oil companies a scapegoat. In the future, would the oil companies' response to market forces provide supplies adequate to meet the growing demands?

This morning, two members of the administration, Mr. Herbert Stein, Chairman of the Council of Economic Advisers, and Mr. John C. Sawhill, formerly head of OMB's Division on Natural Resources and now designated to be Deputy to the new Energy Chief, William Simon, will testify. We will also hear from Ms. Anne P. Carter of the economics department at Brandeis University, who worked on input-output analysis for several years with Nobel laureate Wassily Leontief. Finally, Mr. George B. Hegeman of Arthur D. Little, Inc., will testify on the particular problems of the petrochemical industry. We are always glad to have you here, Mr. Stein. Under the rules, and without objection, your statement will be received in full in the record, as will that of Mr. Sawhill and the other witnesses. You may proceed.

STATEMENT OF HON. HERBERT STEIN, CHAIRMAN, COUNCIL OF ECONOMIC ADVISERS

Mr. STEIN. I welcome the opportunity to appear here today to discuss the economic consequences of the energy crisis.

You may think I say this to all of the committees. But I specially welcome the entry of this committee into this subject because you are the economic analysis body of the Congress, and I think the subject clearly needs serious and overall economic anaylsis.

There have, of course, been hundreds of days of congressional hearings on aspects of this subject in the past few months and millions of words written about it-that's a rough estimate. Still there is a great need in the country for more information and understanding about the energy crisis and I hope that your hearings will help to meet this need.

While there is much about this subject that is unclear, one thing does seem clear. The energy situation will confront the country with serious dangers, difficulties, and uncertainties. The world is a dangerous, diffcult, and uncertain place. If we ignore this, or try to act as if it were not true, we will not survive in such a world. We simply will not be able to protect everybody against pain, or to achieve everybody's ideal of equity in the distribution of that pain. If we insist on trying to achieve these impossibilities as the price of cooperation in the vital national effort to deal with the problem, we shall put our independence in jeopardy.

I receive a lot of mail from people who are appalled by my saying this, but I believe this is the thing to say.

The Government's effort will be to manage the difficult situation ahead in a way that makes its costs as little as possible. But these costs

will be serious if the embargo continues. Nothing I say here should be interpreted as signifying anything different. I do believe that some estimates of our prospects are unrealistically pessimistic. But it seems obvious to me that a 15- to 20-percent cut in our oil supply must have a serious effect. Our main concern at present, in my opinion, is not to argue about forecasts of these effects but to try to find out how to keep them as small as we can.

We have to deal simultaneously with two related conditions, one short run and one long run. The shortrun condition is the crisis caused by the Arab embargo on shipment of oil to the United States. Here we have two goals. We want to minimize the immediate loss of goods and services fairly directly provided by energy, such as heat, light, and personal transportation, but also of the vast array of other things whose supply is dependent on energy. How well we achieve this goal depends in part on how well we allocate the available supply of oil and other energy sources, because some uses of energy yield more output than others. Achievment of the goal depends also on bringing into use every potentially available bit of energy. The second shortrun goal is to avoid unnecessary concentration of the burden on particular individuals. One of the main implications of this is the importance of holding down unemployment. Many of the other adverse consequences of the energy shortage, such as colder houses or less auto driving, tend to be shared by large numbers of people, or at least policy can be devised for sharing them widely. However, unemployment is inevitably much more concentrated.

The longer run problem is the one that existed before the embargo and that will continue even after the embargo has been lifted. It is to make sure that we develop as quickly and efficiently as possible all economic supplies of energy from reliable sources. That is what Project Independence means. The longer run problem concentrates on the expansion of reliable supplies. However, reliable supplies of energy in 1980 will almost certainly be more expensive, relative to other things, than energy has been in the recent past. This will hold down consumption of energy compared to what it would have been at lower prices. The shorter run problem, on the other hand, is chiefly to allocate the available supply. Nevertheless, even in the short run some expansion of supply will be possible and it is essential to obtain it.

Estimates of the magnitude of the shortages are, of course, forecasts and subject to some uncertainty. The calculations which we at the Council of Economic Advisers have made about the economic impact of the shortage are based on estimates available last week. In the last few days there has been some information suggesting that the shortage may be smaller than we have thought. If so, that would certainly be good news and would call for some revision of the estimates presented here. However, we have not had sufficiently clear new estimates of the shortage to incorporate any in new estimates of the economic consequences, although we hope to amend our estimates later in the week.

The estimates of the shortage that we have worked with are as follows: For this purpose I refer to the first quarter of 1974, on the assumption of a continuing embargo. And, as far as we can see, the situation will be at least as tight in the first quarter as subsequently in 1974. Total demand for petroleum products is estimated at about 20 million

barrels a day, if the economy is rising above its 1973 level of output by 2.5 percent per annum. This estimate also assumes no change in prices of petroleum products from mid-1973 levels.

The demand would include about 300,000 barrels a day of military requirements that is, incorporated in the 20 million-previously met from foreign sources but now expected to be met from domestic supplies. The estimated supply of petroleum products, from domestic sources, from imports and from inventory reduction, is 16.5 million barrels per day. The supply would have been 3.2 million barrels per day higher if there had been no Arab supply restrictions. Thus the shortage, which results from the embargo, would be about 3.5 million barrels a day, or about 17.5 percent of the estimated first quarter demand.

Although petroleum is the largest single source of energy in the United States, it still accounted for less than half of our use of energy in 1972. The shortage of the total supply of energy from all sources will be about 8 percent. The other sources of energy-natural gas, coal, hydropower and nuclear power-are not totally substitutable for petroleum. However, there are enough possibilities for substitution to make the calculation of the total energy shortage significant.

The economic effect of this shortage will depend on how it is distributed among the various uses of energy. Some uses of energy involve relatively little processing on their way to the final consumer. Thus crude oil which becomes home heating oil goes through a certain process of refining and transportation which would be common to any use of crude oil, but not much more than that, except for the home delivery. However, crude oil which becomes diesel fuel for running a railroad which carries coal to a steel mill which makes steel which is subsequently manufactured into an automobile which is sold by a dealer to a consumer is an essential element in a long chain of production and employment. To deprive a railroad of a barrel of diesel fuel will have much more severe effects on output and employment than to deprive a household of a barrel of heating oil. Cutting private passenger car use of gasoline, at least down to a certain point, would also have relatively small effect on output and employment. There would, of course, be some indirect consequences. • A reduction of private gasoline availability will reduce demand for many associated activities-automobiles, or at least large automobiles, auto repairs, motels, resorts and so on. But on the average the loss from this would be less than from cutting industrial uses or freight transportation.

One element in the administration's strategy for dealing with the shortage is to make the heaviest cuts in heating, including residential heating, and in gasoline consumption, especially private car use. There are, of course, limits to the possible extent of this. Home heating must not be reduced below a level essential for health; a certain proportion of private car use is necessary for getting people to work. On the other hand some industrial and commercial uses of energy

can be eliminated without serious effects on output and employment. So one cannot formulate a general principle that regardless of the extent of the shortage all energy cuts should come out of household heating and transportation. But in the particular circumstances we face, and given the fact that every act will be to some degree painful, we think that damage will be minimized if cuts come largely out of those uses.

If the cuts in private passenger car use of gasoline are to have their desired effect in avoiding energy cuts for industry we must reduce as far as possible the gasoline obtained from a barrel of crude oil and increase as far as possible the other products obtained from the barrel. The Government has taken a number of steps to achieve that, including a rearrangement of the relative prices of gasoline and other products to make production of gasoline less attractive.

Another element in the strategy is to convert from use of petroleum to use of other fuels. The Federal Energy Administration is working with a number of utilities that have recently converted from coal to oil for the generation of electricity to switch back. Another vital conversion is indirect. Many industries are set up to use either natural gas or petroleum, generally preferring gas at existing prices but using petroleum if the gas is not available. A cut in the use of natural gas for home heating will make more of it available for industry. That is why it is just as important to turn down thermostats in houses heated with gas and the same applies to electricity—as in houses heated by oil.

An additional element in the strategy for dealing with the present crisis is to get all the increase in energy supply we can. That will not be much in the short run, but it will be something. We have asked for authority to extract oil from the Elk Hills petroleum reserve. We have asked Congress for authority to override State restrictions on oil production. We have asked Congress to remove ceilings on prices of additional supplies of natural gas, which will both get more gas produced and get more moved to where it is most needed. We expect that increases in other prices of energy will be helpful in achieving an expansion of supply.

With this view of the extent of the shortage and the basic strategy for dealing with it, we have tried to estimate the effects of the shortage on output and employment. These effects would come partly from the supply side and partly from the demand side. The main supply-side effects would be in the business of transporting and distributing gasoline and heating fuels. For other industries the chief effect would come from reductions of demand which are the indirect consequence of the shortage of gasoline. That is, there will be less demand for large cars, for tires, repair parts, certain tourist activities and so on. There would be some reduction in the supply of energy directly to industry but in the magnitudes we envisage this would not be a significant limit on the industrial output for two reasons. First, there is some room for conservation in industrial uses. Second, output lim

itations from demand reduction and output limitations from inadequacy of energy supply are not additive. Thus, if the gasoline shortage reduces the demand for large cars and cuts total automobile output this will reduce the requirement of the automobile industry for energy, permitting diversion of some energy to other industries and preventing them from being cut back by a shortage of energy.

One must emphasize that in estimating how much demand for output will be cut back by the energy shortage one is operating now in the area of almost total ignorance. If we cut gasoline consumption 30 percent, to what extent will people economize on their usual trips around town and form carpools, saving their gasoline for the longer trips on which they patronize resorts and restaurants? If they reduce their expenditures on gasoline-related consumption will they increase their expenditures for other consumption? The net effects on business investment and on exports and imports are similarly difficult to appraise, at least until we see more reaction to the new situation.

Nevertheless, we did try to make reasonable guesses about how consumers and businesses would behave and to trace the repercussions through the economy. This process led to a range of estimates of the net effect on real output, the range reflecting different assumptions about the degree and speed of consumers' substitution of other purchases for their purchases of energy-related products. Our estimate is that the energy crisis would make the real GNP between 1 and 2 percent lower than it would otherwise have been. On this basis, the increase of real GNP between 1973 and 1974 would be in a range from a little under 1 percent to a little under 2 percent. We translate this into an increase of unemployment in 1974 by about 0.3 to 0.6 percentage points above what it would otherwise have been. We would not expect the unemployment rate at any time in 1974 to exceed 6 percent. These estimates, made in this way, seem to imply a painless process. Of course, that is not realistic. The estimates of output loss and employment loss summarized here in rather small numbers do not include problems for many individuals and businesses.

These results are rather similar to estimates made by other forecasters. I attach to my statement a table prepared by the Economic Research Department of RCA which neatly summarizes these forecasts. This table, I might point out, shows that among 15 to 20 forecasters that the average estimate of the increase in real GNP from 1974 over 1973 is now 112 percent. When the estimates were made a month ago, before taking into account the energy crisis, the estimated average increase was 212 percent, which indicates a reduction of about 1 percentage point in the estimated rise of the real GNP from 1973 to 1974 that may be attributed, mainly, at least, to the energy crisis.

[The table referred to above follows:]