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So far this month I have been focusing on catching up to various different aspects of the “inflation” conversation that has been happening in the United States. One point I have emphasized is that there hasn’t been a generalized shortage of goods and services across the board since the Coronavirus pandemic began. Instead, there have been particular important inputs and consumer goods experiencing bottlenecks. These bottlenecks have had spillover effects on other parts of the economy. Early in 2020 I described the initial phase of the pandemic as the tricky task of “safely mobilizing people to produce more safety equipment and then mobilizing non-front line workers with spare safety equipment to meet other needs. The production of N-95 masks by means of N-95 masks, as it were.”
In 2021 the bottleneck in safety equipment abated but new bottlenecks emerged in semi-conductors, wood products, meat and oil (among a few other products). These particular bottlenecks had outsized impacts on the overall economy, and consumer price indices. Energy, meat and semi-conductor related car prices have been overwhelmingly the source of higher measured “inflation”. That means these particular industries have been critical to the call for the Federal Reserve to raise interest rates.
While a pandemic was not at the front of my mind in 2019, a scenario much like this did occupy my mind in 2019. In fact, it was almost all I could talk about. At a time of persistently low interest rates and low inflation, I was concerned about how proposals to transform the economy (such as the Green New Deal) would run aground on localized bottlenecks, rising measured inflation and rising interest rates. In a Financial Times op ed published March 2019 by my colleagues Rohan Grey, Scott Fullwiler and myself wrote about the various institutional changes that would need to be made to proactively respond to inflation while engaging in large spending projects. We emphasized, in particular, that elevated price indices were neither necessary nor sufficient evidence of bottlenecks:
Regardless of which policy tool is used in a particular context, demand management in general needs to lean much more heavily on the appearance of bottlenecks in specific industries instead of simply tracking changes in a general price index. The immediate signs of bottlenecks are large and sustained rises in unfilled orders for specific goods and services. Preventing shortages is after all what demand management is first and foremost about and price indices are misleading policy targets when they include factors that are insensitive to demand and would be counterproductive to manage with demand.
In other words, we were warning in advance that higher inflation wasn’t strong evidence of excess aggregate demand, and that bottlenecks which require policy responses could emerge without any sign in CPI. This warning, to say the least, has not been heeded. But it points the way towards what a better policy suite could have been.
The particular bottlenecks which emerged in 2021 have been made worse over time by the reluctance of businesses in these sectors to speedily increase investment in response. To understand why, it would be useful to go back to the most basic — but too often forgotten — elements of John Maynard Keynes’s General Theory of Employment, Interest and Money. In particular, his idea of “effective demand”.
I could spend a lot of time talking about this idea — there are whole books that in fact do this! But instead I will be emphasizing one particular element. In my writing in Notes on the Crises — and in other writings about macroeconomics — you will see the term “demand”, the phrases “aggregate demand” and “excess aggregate demand”, and other variations used regularly. These terms are useful, if in large part just to understand what orthodox economists and policymakers are saying. However, they don’t tell us the whole story. In the General Theory, Keynes focuses on defining and refining his idea of “Effective Demand”. The key difference between aggregate demand and effective demand — and the most important element for our purposes — is that effective demand refers to the expectations of “entrepreneurs”. Effective demand is not simply the actual sums of money being spent, or preparing to be spent, “out there”. In our world, we can simply think of the expectations of firms rather than “entrepreneurs”. If those in charge of firms are pessimistic about future sales, effective demand will be low. That’s true regardless of the factors impacting aggregate demand.
Of course, in the immediate future, it is hard to imagine this kind of mismatch sustaining itself. If a firm doesn’t produce because it expects its products to remain unsold, the sales and market share growth of its competitors will likely change its tune. It does not, after all, take all that much to restart production that has been recently mothballed (abstracting from sudden bottlenecks of key inputs).
Keynes understood this point well, which is why he divided expectations into two types. “Short term” expectations referred to the expectation that a firm can sell what it can produce with the plant and equipment it already controls. “Long term” expectations are "concerned with what the entrepreneur [firm] can hope to earn in the shape of future returns if he purchases (or, perhaps, manufactures) 'finished' output as an addition to his capital equipment". In other words, long term expectations relate to whether the sales will be there to make building more capacity, or even an entire new factory, worth it.
Here lies the issue. Keynes highlights that: "The actually realised results of the production and sale of output will only be relevant to employment in so far as they cause a modification of subsequent expectation". If sales growth in 2021 or 2022 doesn’t lead to expectations of higher sales in 2027 and 2028, businesses have no reason to invest in plant and equipment with multi-year, perhaps even multi-decade, lifespans.
Now it is likely that years upon years of annual sales growth could eventually align “short term” and “long term” expectations. However, that would take quite a long time. This possibility is also being currently closed by the Federal Reserve. Chairman Powell is doing his best to validate business expectations that effective demand has not increased by lowering aggregate demand today. In a sense, interest rate policy is closing the gap by perversely lowering short term expectations until they are in line with long term expectations. Even more perversely, their very unwillingness to invest in new capacity has contributed to the elevated CPI readings, which have led to elite pressure on the Federal Reserve to lower inflation through choking demand.
Which brings me to my colleagues at Employ America. They recognized this issue early on in 2021 and have been aiming their output at making policy recommendations to ameliorate them. Two weeks ago I covered their recommendations for bringing down price growth in sectors that are not experiencing bottlenecks. The other half of their output has been devoted to particular bottlenecked sectors and what can be done about them. In May they called their analysis the “The Physical Capacity Shortage View of Inflation”. If we can’t quickly break through pessimistic expectations that are lowering “long term effective demand” by boosting “short term effective demand”, we need to either directly invest in additional capacity or insure firms against negative surprises in the future.
On this general point, I agree with Employ America. And if their proposals only applied to relatively minor (though economically important) sectors like the semi-conductor manufacturing industry, I would not voice any objection. However, they are not just making proposals in these sectors. They are also proposing insuring the oil and gas industry against costly surprises, in order to sustain and boost oil and gas investment. To summarize briefly, their proposal is to have the Treasury use a facility called the “Exchange Stabilization Fund'' to sell oil producers a financial contract that would protect them from declines in oil prices. These types of contracts- called “put options''- give their holders the option- but not the obligation- to sell oil at a previously agreed upon price to the U.S. government. The government could then, in turn, take physical delivery of oil and add it to the Strategic Petroleum Reserve.
This is a very well thought out and creative proposal. I have no doubt that it is one way to stabilize oil markets. However, as someone who focuses on climate change as a topic for economic policy, I must object. There are particular glaring factors which make these kinds of schemes inadvisable in the Oil and Gas industry, even if there is a good argument for them elsewhere.
To state the obvious, fossil fuels are the core source of carbon emissions. They are, along with other greenhouse gases, preventing heat from escaping into space and gradually warming planet Earth. Burning as little remaining fossil fuels as possible while we pursue electrifying our economy and, at the same time, decarbonizing electricity production is the main mission humanity has in the 21st century. In turn, the oil and gas industry is the main political opponent which advocates of combating climate change have to defeat (though by no means the only one). Making sure that the oil and gas industry doesn’t bear the downside uncertainties inherent in oil and gas investment strengthens this industry — and makes it more difficult to defeat.
This political basis alone would be enough to object to such proposals. Yet, the issue at hand is worse than this. The very problem these proposals aim to solve shows us why it's a bad idea in this case. While we can’t get rid of fossil fuel infrastructure overnight (to say the least!) we have to avoid incentivizing a big jump in Oil and Gas infrastructure and capacity. Recall that the argument for these kinds of proposals is that the plant and equipment involved last for long periods of time, and thus short term increases in sales can’t overcome long term pessimistic expectations. This means any oil and gas investment these schemes successfully induce will be around for at least a decade. And in some cases, 20 years or more. The timeline under which we need to stop removing oil from the ground and burning it is far more strenuous than that for our existing oil and gas infrastructure.
Of course, this is an industry that is currently experiencing bottlenecks. Those are causing disruptions and those disruptions will likely get worse during the winter. Simply not increasing oil and gas investment will not solve these problems. Even worse, high gas prices are a major political stumbling block to climate action. Decarbonization works best politically when it emerges before disruptions to the Oil and Gas industry and envelopes the economy before drivers see any pain at the pump. (Ideally, without any pain at the pump at all). A fossil fuel bottlenecked and dirty economy is an improbable candidate for aggressive climate action. This is something I agree with Employ America researchers about, and is thus a criticism of mainstream climate policy advocates I share. Carbon pricing and institutional investor disinvestment have gotten far too much attention relative to the transformation the economy — and our energy grid- needs and the aggressive fiscal policies needed to make that happen. The action has been more on the demand side than has been commonly acknowledged (in fact far more so).
However, none of that means we need more fossil fuel infrastructure. There are many ways of tackling energy consumption today (and reducing emissions) while cooling the global oil and gas market. Paul Williams, Yakov Feygin, Chirag Lala and Mitch Green put out a report last month entitled “Cooling oil consumption to ease price pressures”. They get to the heart of the matter with five broad ways to get oil consumption down:
- Fare holiday to get people on buses, trains and micro-mobility as quickly as possible
- Compress timelines for transit infrastructure investments to grow ridership base
- Incentives for firms to allow and encourage employees to work from home
- Encourage carpooling with incentives and a bully pulpit campaign
- Consider a national speed limit reduction
Readers can agree or disagree with one or more of these proposals, or declare that they would not be enough. However, the point is, in the case of energy, we have a lot of levers that we can move before we try to increase oil and gas investment. Get other smart people in a room, and at least a dozen more good ideas will emerge. The International Energy Agency has produced its own ten point plan to reduce oil use which overlaps with the Center for Public Enterprise’s proposals. To be clear: I know the folks at Employ America do not oppose these measures. However, I do not think proposing subsidies — however uniquely structured or well designed those subsidies are — for the oil and gas industry is appropriate. At least not as long as there are so many other options to pursue.
Employ America are respected for doing serious analysis because they do serious analysis. I suspect (though do not personally know) that there are officials in the Biden administration who listen to them. I think this for the simple reason that they are one of the few organizations consistently putting out realistic, sectorally informed and detailed proposals responding to current economic problems. When important organizations like Employ America put these kinds of proposals on the table, they legitimate them. An administration looking for easy and quick fixes will gravitate to the easiest and quickest fix offered by people who know what they are talking about. That is dangerous when it comes to oil and gas. As a result, I strenuously disagree with this proposal being accepted, and call for others to reject it as designed. Economic policy advocates, officials and staffers should start from the position that fossil fuel infrastructure should not be supported or subsidized without countervailing regulation, public ownership or stipulations . I hope my friends at Employ America junk it as well.