May 8, 2004

#158: At last, some actual economics from the famous economist!

P. Krugman

The Oil Crunch (05/07/04) by Paul Krugman is a desperate attempt to find a rain cloud in an otherwise increasingly sunny economic sky. The only crunch we can see is "crunch-time" over at PK headquarters. He tries to make a case that currently high oil prices are becoming a serious problem for world economies. The trouble is he can't make that case without acknowledging that a world-wide economic recovery is underway.

After an obligatory swipe at the Bush Iraqi war policy for contributing to the problem he notes:

"Even if things had gone well, however, Iraq couldn't have given us cheap oil for more than a couple of years at most, because the United States and other advanced countries are now competing for oil with the surging economies of Asia."
Say What? Surging economies? Supply shortages? Seems like only yesterday Krugman was pissing and moaning about the specter of world deflation Japanese style (remember Mind the Gap) or a double-dip in the U.S. economy (remember Dubya's Double Dip?) or a "jobless recovery" (remember Jobs, Jobs, Jobs?). He moved from deflation to inflation without acknowledging (much less, celebrating) the long spans of prosperity that occur between. It's like passing GO without collecting 200 bucks.

But Krugman's most grievous error is one for which he would flunk any student in his Principles class at Princeton:

"Oil is a resource in finite supply; no major oil fields have been found since 1976, and experts suspect that there are no more to find."
This is absurd. Natural resources do not have a finite supply in any economically meaningful sense. Their supply curves slope upward and to the right like any others. Higher prices always bring out more quantity, i.e., a movement along the supply curve. There are boundless examples. Drill a little deeper, find fields that were marginal at lower prices, move a little further off-shore, etc. Then there are technological advances aimed at reducing extraction and various delivery costs. These advances shift the supply curve to the right thereby increasing the quantity at all price levels. Examples are development of deep sea drilling rigs and modern pipeline technology that makes delivery possible from remote regions, e.g., Russia and Kazakhstan. Higher prices also work on the demand side by encouraging conservation (turning off lights, carpooling, etc.) and new technology directed toward alternative energy sources. How all of these factors work themselves out over time cannot be predicted with any precision. We never run out of anything, but as scarcity becomes more and more of a problem, old energy technologies price themselves out of the market and new technologies arrive. As long as markets stay free and investments are rewarded a resolution is assured.

There are many historical examples of this process. If we were transported 200 years back in time Krugman probably would be whining about high whale oil prices and how we are running out of whales. In fact, whale oil was still with us as recently as 30 years ago when sales were banned except from existing inventory. However, as a major fuel source, whale oil was bypassed a hundred years ago by superior technology. In time fossil fuel will itself be bypassed by a cheaper energy source. HOWEVER, that time may be a long, long way off.

As shown in the chart below, current oil prices in real terms are not particularly high–certainly not alarmingly high compared with past history. For computational reference, the first observation in the chart, Jan 1974, is 956 cents per barrel divided by a GDP deflator of 33.38 gives a real index value of 28.6. If the chart were updated through April 2004 the index would now be about 32.0. This clearly constitutes an uptrend but real prices have not reached the peak seen in the Gulf War and are nowhere near the levels during the energy crises of the late 70s.

Real prices of imported crude oil, 1974-2004

If fossil fuels are to be displaced by another technology it will take more than beltway sideshows–politicians pandering to greens and promising subsidies for alternative energy boondoggles. A new technology will have to win it in the trenches with consumers and we don’t see that happening any time soon.

[The Truth Squad is a group of economists who have long marveled at the writings of Paul Krugman. The Squad Reports are synopses of their discussions. ]

Posted by John Weidner at May 8, 2004 11:27 AM
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