Friday, August 4, 2006

The Price of Gas, Part II -- Gouging & Inflation

Gouging – most people don’t understand what this term means, or at least when it is a bad thing. Folks see Exxon/Mobil posting $10B earnings in a quarter and say we’re being gouged at the pump for gas. Meanwhile they pay a higher price/gal for bottled water without blinking an eye. If the oil companies are operating substantially without government subsidy, then I think they should be able to keep raising the price until they feel they’ve maximized profits. Of course, they do get government subsidy in the form of tax incentives, so that makes things a little messier. But we won’t wean ourselves off petroleum until we are individually driven to change our behavior and seek alternatives. Classic economic theory would argue that the best thing for our country would be for the oil companies to raise the price, generate huge profits, and pay out a substantial fraction of those profits as dividends. That releases capital to be invested into other enterprises, some of which are likely to seek what comes after oil (which might not be limited to energy – it might be about further upgrades to the telecom system so that telecommuting is even more practical).

To me, gouging happens only in the face of a disaster, when an absolutely essential commodity is in the hands of a few, and those few raise the price to exorbitant levels, taking advantage of the situation. This happens rarely, and almost never in this country. What would you say if a cabbie in Manhattan on 9/11 said he would give you a ride, but for 10x the meter? If you a pregnant woman who needed to get to a hospital, I’d call that gouging. If you were a snotty upper East sider, I might say it’s just capitalism.

Inflation is another concept most people don’t understand. Properly defined, inflation occurs when the government adds currency to the economy faster than the growth in GNP. Having gas prices go up is not inflation. A key component of capitalism is the process where a producer raises prices to the point that consumers seek alternative answers to their needs and desires. If increasing gas prices causes me to lack the disposable income to buy other stuff I would like to have, then I am motivated to solve the problem of higher gas prices. I might buy more efficient car, or use more mass transit, or move close enough to my job and food source that I don’t need a car anymore (which is why poor people across the globe flock to cities).

Things are somewhat neutralized if my employer feels some obligation to raise my pay enough to offset the increase in gas price. But this still isn’t inflation. Presumably the employer must divert some resources away from other things to raise my pay. The employer might try to raise the price of their product to pass the cost on down the food chain. That still isn’t inflation, because the buyers of those products have the opportunity to pay the higher price or find another supplier. The rise in oil prices definitely has a ripple effect through the economy, but it’s exactly what needs to happen. Everyone feels a little piece of motivation to solve the macro problem.
Inflation happens when the government comes to the conclusion that the economy is slowing down, and that a way to stimulate it is to make money cheaper. They do this by massively increasing the amount of debt instruments they offer at the primary auction, in which the primary bond traders bid on the instruments by offering how much interest they are willing to pay. When government bonds are plentiful, they bid lower rates, which causes that influx of money to get passed on to the economy at a lower rate. When debt is cheaper for employers, they might be able to restructure their debt at a lower rate and free up some cash flow to pay higher salaries and higher prices for their other purchases. At the end of the day, nothing has changed as far as relative price (e.g. everything except money costs 1% more), and there is no motivation to change behavior.

But these money supply infusions are an addictive drug. The underlying dynamics aren’t changed, and the free market forces which would flow from the behavior changes driven by individual purchasing choices get squelched and perverted. As the new money is absorbed into the economy, it can seem like things are okay, but they're really not. Lenders begin to take note that long term debt is getting risky because the buying power of a dollar is being diluted, and so they increase lending rates. That wave works its way through the economy as higher borrowing costs for everything from houses to credit card debt to school loans.

The Fed is doing exactly the right thing by keeping the money supply under control (they don't control interest rates, they control the money supply -- notice that they talk about interest rate 'targets' they hope to achieve by controlling the amount of Treasury debt that place on the market -- see above). The last thing in the world we want is for them to dump a bunch of money into the economy to lower interest rates in the short term, because it starts a dangerous cycle and ultimately causes interest rates to go up.

So the let the gas companies charge all they can get away with. It's good for all of us.

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