Government Price Manipulations
and Fictional Economic Booms

Paul A. Cleveland

Paul A. Cleveland is Assistant Professor of Economics and Business Administration at Birmingham-Southern College

I. Introduction

The Austrian theory of business cycles focuses attention on the misallocation of capital from lower to higher stages of production as a result of an easy credit policy which masks the true social time preference. This explanation of business cycles was developed by Friedrich Hayek in his book, Prices and Production. Hayek's work is unique, for it integrates price theory, monetary theory, and capital theory in a microeconomic explanation of macroeconomic aggregates.

In his theory, "Hayek viewed the price mechanism as a system of signals and the 'economic problem' as one of social coordination."{1} Within the context of the theory, production is seen to occur in stages and capital is employed at the various levels of any production process. Hayek refers to the capital in the earlier stages of a process as higher order capital goods and that in the later stages as lower order capital. An expansion of credit serves to artificially lower the cost of funds which falsely signals an increase in the value of capital goods at higher stages in the production process. As more capital is employed at earlier stages, the prices of certain resources are bid up depending on how the credit was introduced into the economy. As a result, some of the capital investments are not sustainable and must later be liquidated. However, before the economic reality of the situation is discovered, some sectors of the economy experience a temporary boom which must later give way to a bust.

For example, suppose that the monetary authority decided to introduce new money into the economy by giving it to people who loved to eat hamburgers and they used the money to purchase hamburgers. Restaurants that make hamburgers would see this as an increase in the demand for their products and would begin to expand their production capabilities. Producers of the capital equipment desired by the restaurants would in turn see this as an increase in the demand for their products and make the necessary capital investments needed to expand the production of their equipment and so on. However, underlying preferences in the economy have not really changed. Nor, has there been any real change in the availability of resources. Thus, eventually relative prices must change such that the true underlying demand for hamburgers becomes apparent once again. When this happens, it will be evident that some of the capital investments were made in error.

This same situation can, and in fact does, result from the government's attempt to manipulate other prices through its regulatory efforts. This follows since "capital goods can be shifted...from one production process to another in response to relative-price changes."{2} Therefore, when government regulators attempt to control prices of certain goods, it results in a distortion in relative prices. Since decision makers rely on these prices as signals for allocating capital investments to the most profitable uses, poor decisions will follow. The extent of the misallocation will depend on the length of time regulators mask the true preferences of individuals in the economy. Furthermore, the period of the bust following the boom will depend upon the ability of decision makers to reallocate capital, as well as any other misallocated resources, to alternative uses.

It might be argued that having knowledge of the disinformation imposed by the regulators would serve to mitigate this situation. However, that is not the case. In the first place, regulatory control creates profit opportunities. As long as these exist, even if they are artificial, someone will have the incentive to capture the profits by making the necessary capital decisions. Additionally, the most disruptive regulations are typically employed in situations of abrupt change. In such cases, there is no way for decision makers to know the true situation even if everyone understood the economics of the government's deception.{3}

The purpose of this paper is to examine a case where government regulation resulted in the misallocation of capital. The relevant regulations were imposed for a seven year period and resulted in a boom in a particular segment of the economy. When decontrol finally came, an economic bust occurred. During the bust, large amounts of capital were idle because they had been allocated on the basis of a price fiction created by government regulators. The industry in question is the oil industry. The paper will focus on an economic boom and subsequent bust which took place in oil producing states as a result of public policy mandates during the energy crisis.

II. A Brief History of the Oil Industry During the 1970s and 1980s

Early in 1984 the federal government decided to shred 4.8 billion gasoline-rationing coupons that were stacked in sealed ammunition bunkers in Pueblo, Colorado. They had cost $12 million to print, and were costing taxpayers $20,000 a year to store. The Reagan Administration had no intention of ever using them, and their existence was troubling at a time of falling prices for petroleum products everywhere in the world. They symbolized in a poignant manner the fears and frustrations engendered by years of anguish over energy. So the best solution was to dispose of them and be done with the matter. The energy crisis was over.{4}

The opening paragraph of Tugwell's book on the energy crisis seems like more than an appropriate place to start examining the oil industry as it progressed through the turbulent 1970s and early 1980s. Certainly, the best solution in 1984 was to destroy the rationing coupons that the government had printed during the 1970s. However, as will be pointed out by the evidence, it would have been better still if they had never been printed.

On October 17, 1973, the Arab oil ministers met in Kuwait and agreed to an oil embargo against Western countries. This action is generally viewed as the watershed event resulting in an energy crisis in the industrialized world. It is widely believed that the United States was held hostage by the Arab producers because of its declining domestic reserves and its increasing dependency on imports in the years before OPEC. As one source reported, oil imports had increased as a percentage of total consumption from 13 percent in 1950 to 23 percent by 1970. As this writer continues, "even these disturbing statistics on oil imports as a percentage of total oil consumed masked somewhat the growing dependence on foreign oil, since the absolute consumption of imports kept pace with the near-tripling of domestic demand for petroleum between 1950 and 1975."{5}

Yet, there is something fundamentally wrong with this explanation. Even though it may be made to fit the data of oil consumption during the energy crisis, it does not explain the end of the crisis in the 1980s when the price of oil stabilized at lower levels. Nor does it seem to fit well with the economics of the matter. Other things equal, an increase in the price of imported oil should serve to motivate domestic producers to offer more of their reserves to the market. One would expect that domestic production would rise and that imports would fall immediately after an embargo such as that orchestrated by OPEC. However, the exact opposite actually occurred, as is shown in Table 1, and the story offered above seems like a stretched attempt to make some sense out of the data. The answer to this puzzle can be found by considering the regulations being imposed at the time.

Prior to 1973, the Nixon administration was engaged in a series of price controls to combat inflation. This policy had already had some impact in the oil industry and had led to shortages of oil even before the embargo. This situation is reflected in the decrease in domestic production in 1971. As mandatory price restraints were lifted, domestic production soared to relieve the shortages. The embargo at the end of 1973 added an additional shock to a market that was already in transition.{7} As a result, even as general price controls were lifted, shortages in the oil industry continued because of other regulations which were imposed in the energy industry.

The most significant piece of legislation imposing new regulations on the oil industry during the 1970s was passed by Congress just a few weeks after the embargo. Its timing gave the appearance of a quick legislative response to OPEC's action. However, in reality the bill had already been working its way through Congress. The bill was titled the Emergency Petroleum Allocation Act (EPAA). One of the significant features of the law was the creation of a two tier pricing system. The first tier was defined as known domestic oil reserves. On the basis of the new law, these reserves were closely regulated and could only be sold at pre-embargo prices. As time continued, the law did allow first tier prices to drift upward; yet, the prices were kept lower than world market prices for similar grades of oil. The second tier was defined as all other sources of crude oil. There were no controls imposed on the production or distribution of reserves classified in this tier.{8}

The economic impact of this legislation should have been obvious. In particular, the incentive to owners of known domestic reserves to pump the oil and sell it in the market place was reduced by artificially low prices. Owners of tier one oil were essentially encouraged to hold their supplies off the market. The policy served to keep world oil prices artificially high by disallowing competition from owners of known domestic reserves. Alternatively, owners of tier two oil reserves were allowed to compete at world prices. For domestic producers, the only way to compete was through exploration for new oil reserves. But exploration takes time. New reserves cannot be found overnight. This system of regulation put into place a reward system which resulted in an economic boom in the industry for the exploration and development of new oil reserves beyond what would have been warranted by the OPEC embargo alone. It also resulted in the escalation of the importing of crude oil into the United States.

This explanation is consistent with the production and importation data given in the table above. Notice that domestic production falls in each of the years 1974-1976. During this same period of time, the importation of crude oil increased dramatically in each of those years. This period coincides with the period of time needed for oil exploration to find new reserves. Thus, as owners of known domestic reserves held some of their oil off the market rather than accept an artificially low price, the nation became more dependent on foreign sources. At the same time, however, an artificially high economic profit was available for those who could successfully find and develop new oil reserves. By 1977 it appears that exploration for new oil was resulting in higher domestic production and, for the first time since the embargo was imposed, some competitive pressure on OPEC. Nevertheless, the higher levels of imported oil continued until 1980. This date is significant because during this year President Carter had failed in his attempt to get Congress to continue regulatory control under the EPAA. As a result, the regulations established by the act were scheduled to end. Deregulation became even more certain when Reagan was elected president.

In the early 1980s, in a deregulated environment, all oil producers were free to sell their oil at world prices. Domestic production increased modestly and the importation of crude oil plummeted. Other things equal, it might be expected that domestic production would have grown much more rapidly than it in fact did. However, other things were not equal. During the years of regulation, substantial technological advancements were made which improved the fuel efficiency of automotive engines. These advancements resulted in a reduction in demand for petroleum products below what would otherwise have been the case. As a result, the decontrol of domestic production and distribution of petroleum, coupled with technological improvements which lowered demand for oil products, resulted in the plentiful supply of crude oil in world markets. In turn, oil prices finally began to fall and have since stabilized.

III. The Misallocation of Capital Resulting from the Regulation of Crude Oil

During the seven year period of price regulation over crude oil reserves, numerous misallocations of capital occurred. These include, but are probably not limited to, the following areas. First, the controls created a marked competitive disadvantage for American automobile manufacturers. The price of crude oil was much higher than it would have been if domestic producers had been allowed to fully compete. This situation was totally unforeseen by domestic auto manufacturers who were not engaged in designing cars to promote fuel efficiency. As a result, they were forced to invest more heavily in research and development of fuel efficient engines years before such investments would have actually been warranted given the true availability of crude oil. Such investments were not painless. In fact, domestic manufacturers suffered substantial losses in market share to foreign producers during this period of time. To be sure, the technological gains made as a result of the R&D expenditures will not be lost, but the full opportunity cost of such expenditures will remain unknown. Additionally, no one can doubt the hardship and costs suffered by industry employees and shareholders who lost jobs and wealth as a result of the loss of competitive advantage.

The second resource misallocation begins with the movement of labor to oil producing states. Because of the restrictions placed upon known reserves, an economic profit in the exploration and development of new oil reserves was possible. Clearly, the embargo itself would have created such a situation. However, government regulations greatly magnified this opportunity beyond what it otherwise would have been. Accordingly, many people began moving to the oil producing states such as Texas as word spread about the economic opportunities available there. During this period of time many new independent oil producers entered the industry and stories abounded about individuals who became rich. The inflow was so large, that some people speculated that the population of Houston, Texas would surpass that of New York City before the year 2000.

The new businesses needed capital equipment. They also needed office space and their employees who moved from other areas of the country needed homes to live in. The result of the creation of new businesses and the inflow of people searching for profit opportunities, was that places like Houston became an excellent place for commercial and residential real estate developments. Such developments are huge capital investments and were financed by numerous individuals and financial institutions including many S&Ls. But, since much of this activity was based upon government regulations restricting trade, such investments were not likely to be viable over the long haul. Indeed, when the bottom fell out, many commercial and residential real estate developments proved unwarranted and unprofitable. Therefore, it should come as no surprise that a large portion of S&L failures of the latter part of the 1980s were centered in oil producing states.

For a number of reasons, much of the S&L investment in these states took place from 1982 to 1985. The general expectation was that oil prices would remain high even with deregulation and, thus, the recent profits would continue for oil producers. Consequently, real estate investments in oil producing states seemed to be sound business decisions. "By the end of 1985 the Texas thrifts (in aggregate) had grown to more than twice their size in the three years since the end of 1982..."{9} A sizable portion of this increase was centered in commercial mortgages and land loans. Though the expansion in capital investment appeared prudent on the basis of levels of current economic activity and past performance, the reality was different. The real boom had already ended, and the evidence of its demise would eventually be revealed in the market. By the mid 1980s, the reality of the situation became apparent. Many of the capital investment projects failed. For example, there were completed skyscrapers in Houston which sat empty and large numbers of people, as they lost their jobs, simply walked away from their homes because they were unable to make their mortgage payments. This is the evidence that capital had been misallocated. The government's manipulation of the price of crude oil over a seven year period had repercussions which disrupted the lives of millions of Americans and led to large losses as decision makers sought profit where none was to be found. In each case, the decisions were based on false information which was the result of the government's meddling in the economy.

IV. Conclusion

Whenever the government attempts to meddle in the market place by altering relative prices in order to achieve some particular end, the result is to redirect resources in perverse directions. The longer the policy is in force, the larger the misallocation will be. In all such cases, the regulator's attempt to control economic outcomes is based upon a small set of preferences rather than upon the general preferences of all market participants. As a result, preferences of individuals are less coordinated than they would have been otherwise. The reality of the misallocation becomes obvious when regulatory policy is ended or altered to serve some other purpose.

The use of government policy to direct economic activity results in outcomes which many people find detrimental to their personal well-being. While a particular policy may create profit opportunities for some people, the boom is fictional and will inevitably result in a bust when the policy changes. Eventually, such changes are inevitable since policy will invariably be altered with the ebb and flow of political fortunes. The end result of state meddling in economic affairs is a mixture of policies which will move the economy from one crisis to the next. Each political change in direction will alter relative prices so as to create new booms while destroying past successes. In addition to this, individual economic development will be hampered because of the false signals being promoted in the market.

The case of the government's regulatory control over crude oil prices during the 1970s provides an excellent example of how such activities disrupt the market. By attempting to soften the initial rise in oil prices caused by the Arab oil embargo, regulators actually compounded the problem. Worse yet, the continuation of regulation during the 70s led to numerous private decisions which would otherwise not have been made. Many of the resource movements prompted by governmental policy would have to be reversed at a later date when the true market conditions became known. To the extent that some decisions proved unwise and yet irreversible, is the extent to which the government's actions led to a real loss in economic well-being in the United States.

Endnotes

{1} Gerald P. O'Driscoll, Economics as a Co-ordination Problem, (Kansas City, Kansas: Sheed, Andrews & McMeel) 1977, p. 67.

{2} Don Bellante and Roger Garrison, "Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics", History of Political Economy, 20:2, 1988, p. 215.

{3} Roger Garrison, "Hayekian Trade Cycle Theory, Cato Journal, (Fall 1986), p. 445-6.

{4} Franklin Tugwell, The Energy Crisis and the American Political Economy: Politics and Markets in the Management of Natural Resources, (Stanford, California: Stanford University Press, 1988) p. 1.

{5} Glenn Porter, editor, Encyclopedia of American Economic History: Studies of the Principal Movements and Ideas, (New York: Scribner, 1980), p. 210.

{6} Brian R. Mitchell, International Historical Statistics: The Americas 1750-1988, 2nd ed., (New York: Stockton Press, 1993), pp. 313 & 411.

{7} The shortage in gasoline due to the embargo was the result of existing energy regulations and not the general price controls of the Nixon administration.

{8} Tugwell, op.cit., pp. 102-12.

{9} Lawrence J. White, The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation, (New York: Oxford University Press, 1991), p. 100.