What Greenspan called the “solid edifice” of free markets may have been discredited, but its power has not. The power of markets is the seamless aggregation of incentives; therefore, to unleash the full power of the free market, incentives must be properly aligned. Obama’s push for tighter emissions standards is an example of a misaligned incentive that will further disrupt the natural pricing of oil.
As many have pointed out, Obama’s toughening of the Corporate Average Fuel Economy (CAFE) standards is inefficient compared to a fuel tax. CAFE’s problem is it creates artificial incentives for certain vehicle types. Because of CAFE, light trucks and SUVs have gone from 10% of car sales to 50% in thirty years. By making these cars cheaper and smaller cars more expensive, CAFE is indirectly encouraging fuel consumption. Also, it makes new, more efficient cars more expensive in relation to old, inefficient cars.
A fuel tax is a much cleaner incentive because it acts directly on the factor the Government is trying to manipulate—fuel consumption. For example, the CBO estimates a $.46/gallon increase in fuel taxes will lead to a 10% decrease in consumption. This incentive is effective because it acts directly on the price elasticity of demand. The higher CAFE standards on the other hand can expect to reach this goal at six times the cost. This inefficiency comes from the distance between the incentive and the target.
Determining the fair value of oil has always been difficult because of the role speculation plays in the process. It is even more difficult when one takes into account the diverse tax and subsidy policies. (For example, India subsidizes and taxes fuel.) Take a look at this graphic for more information on the extent of fuel subsidies. Fuel subsidizing countries have experienced massive growth the last few years, and, since their domestic demand isn't priced according to the global market, oil demand has grown in correlation with GDP. Morgan Stanley estimated in 2008 25% of oil is subsidized when it reaches the ultimate consumer.
Analysts said the recent oil price increase from $50 to $60 a barrel was not based on “fundamentals,” referring to large inventories. It is hard to see when oil prices have ever been based on fundamentals over the last year. First there was “peak oil exuberance.” Then, after September 2008, oil prices have been closely aligned with the stock market. The reason for this correlation is that many expect oil prices to recover when the economy recovers. People seem to forget oil didn’t comfortably reach $60 until 2006, in the midst of a “forward Minsky journey” asset price inflation.
Nevertheless, the truth is simply there will continually be upward pressure on oil prices. If there are more signs of green shoots, prices will rise or linger above $60. Now that states are in fiscally different positions it will be interesting to see how government policies change—naturally we should expect less subsidies and more taxes. But this will not occur until prices start to cause the same damage they caused last summer. The CAFE standards mean that once prices get high again, it will take longer for the US to adapt, because the economic incentives are indirectly tied to their target. It will take countries with high subsidies, like Indonesia, even longer. CAFE standards and subsidies both decrease the price elasticity of demand. As long as governments enact policies such as these, oil is a safe bet.
