Sunday, August 21, 2005

Oil, Activist Government and a Moral Hazard Problem

Economists like to teach their students about the moral hazard problem. Micro economists point out that a home owner is more likely to smoke in bed if she has house insurance that will build her a new house if her home burns down. Macro economists point out that developing nations are more likely to engage in excessive risk taking when they anticipate that the IMF will provide a bailout if their investments sour.

In both cases, expectation of ex-post insurance encourages too much risk taking ex-ante. Home owners and developing nations engage in less self protection than they would have in the absence of the expected insurance.

I wonder if this simple idea applies in the case of oil consumption.

Suppose that the United States government could pre-commit to not take any active role in responding to future oil price increases by encouraging greater supply. This government would not lobby OPEC to increase supply or consider drilling in domestic federal lands in response to higher oil prices. In my thought experiment, I’m cutting off government “insurance” in the oil market. The rational forward looking household would say to itself; “Today the price of gasoline is $3 per gallon. My best guess of the future is that there is a 50% change this price will remain at this level. There is a 25% chance this price will rise to $7 per gallon and there is a 25% chance the price will decline to $2 per gallon.” (Note I’m making up these numbers but each household would have every incentive to go through this scenario planning.)

Households who anticipate a high probability of a really high future price would recognize that in the state of the world where their fears are realized and prices do soar that government has pre-committed to not step in and help them. In the absence of government intervention, these people would have to fend for themselves. How would they do this? The rational household would be likely to take pro-active actions now rather than wait. Such households would purchase greener durables, and configure their lifestyles to protect themselves from being ex-post “price gouged”.

If each of the 300 million people in the U.S followed this strategy, the U.S’s ecological footprint would shrink sharply.

Economists love to talk about “crowding out”. This is a simple idea. For example, the existence of Social Security means that people save less for their own retirement. Another example is that federal transfers to the poor displace private charity. In this post, I’ve suggested a more dangerous “crowd out”. When people anticipate that government intervention will protect them against future price spikes, they have little incentive to take precautionary steps today that in aggregate would green our economy.