The $4/gallon solution

by John Quiggin on September 15, 2004

WIthout much fanfare, the US recorded its largest ever current account deficit in the June quarter, $166 billion. The NYT gave the story a fairly prominent run in the business pages , but the Washington Post ignored it altogether as far as I could see, and CBS Market Watch buried it in small print[1].

At about 5.7 per cent of GDP, this CAD result is at the level at which economists (at least those who are given to worry about unsustainable current account deficits) start getting worried. But, as I’ve pointed out previously, even to stabilise the CAD at this level would require a fairly rapid reduction in the deficit on goods and services. Otherwise compound interest will come into play and the CAD will grow unsustainably. This pattern is already evident in the most recent figures, with a sharp decline in the balance on the income account, due to higher payments to foreign owners of capital[2].

I’ve argued previously that, even with a depreciation of the US dollar, an autonomous smooth adjustment to trade balance is unlikely. The default adjustment path in circumstances of this kind is a currency crisis and recession. There’s also an alternative available to the US as the issuer of a reserve currency. A gradual return to, say, 10 per cent inflation would give the US the chance to wipe out most of its existing debts (at this rate, real values are halved every seven years) and start again with a clean slate. But sweating out 10 per cent inflation is a long and painful process.

So what’s the alternative? There’s one policy intervention that would, I think, have a pretty good chance of restoring balance. Introduce a tax on gasoline and petroleum consumption, and announce that it will rise gradually over time, say from now until 2010, to a level of $2 a gallon on gasoline or perhaps $30 a barrel on oil, domestic and imported (there’s a case, based on costs of road use, for taxing gasoline more heavily than other end uses).

In the long run, demand for oil is reasonably price elastic, and if users knew they faced steadily rising prices, it’s reasonable to expect that a doubling of prices would reduce demand by up to 50 per cent. In terms of motor vehicles, this would bring the US into line with Australia, a highly car-dependent country but one where the price (about $A1/litre) is close to $US4/gallon already about $US3/gallon. . That would bring US demand roughly into line with domestic production, and knock about $150 billion a year off the trade balance. Of course, there are second round general equilibrium effects to be considered, but it’s quite a big potential impact.

There are lots of other benefits. The revenue would help reduce the other deficit, that of the Federal government. The price of oil on the world market would be driven down, which would reduce the income flowing to all sorts of people who can be counted on to use it badly. And there would be some big benefits for the environment.

On the negative side, I can see one minor objection, and one major objection. The minor objection is that the incidence of the tax would be regressive, and offsetting changes in income and social security taxes would be needed.

The major objection is that the whole idea is utterly, totally politically unthinkable.

fn1. However, the story contained the great quote “Get out while there is still an ample supply of fools” from Peter Schiff, president of Euro Pacific Capital, who is urging clients to get out of the dollar as fast as possible.

fn2. Although the official figures show the US as a large net debtor, the income account is roughly in balance. Partly, I suspect, the value of US assets overseas, accumulated over a century or so, is understated. Partly, a lot of US obligations take the form of short-term debt at unsustainably low itnerest rates.



abb1 09.15.04 at 11:29 am

Earlier this year I was watching the Davos economic summit (well, for a few minutes only, I am not that crazy), and Mr. Cheney just ended his speech about combating tourism and speading something all over the middle east, and then the ‘cream de la cream’ of the world’s power elite started asking question. And the question number three was this:

…But there has been one nagging question about the sustainability of that recovery, and that relates to the outlook for the U.S. budget position. In fact, there have been several questions about a comment made by your former colleague, Paul O’Neill, in his new book. (Laughter.) When he quotes that famous meeting that he and Chairman Greenspan had with you, when he recounts you as saying, President Reagan showed that budget deficits don’t matter; could you comment as to whether that is the philosophy — (laughter) — and how you intend to overcome that concern? (Applause.)

And as I was hearing this, I got the feeling that they are finished, gone. The Bush/Cheney team, I mean. Too crazy to serve their masters well.

Well, now, 48 days before the election, it looks like they are getting another term, four more years. How is it possible? Well, there are still 48 days to go. We’ll see…


Brian Weatherson 09.15.04 at 12:29 pm

In what sense is $A1/litre roughly the same as $US4/gallon? By my back of envelope calculations, $A1/litre = $US70c/litre = $US2.65/litre. That’s higher than current US prices, but actually not that much higher than Californian prices, which I thought were hovering in the $2.20 to $2.40 range.

I agree gas prices should be higher, but I don’t think Australia is a helpful point of comparison here.


Tom T. 09.15.04 at 1:16 pm

A small point: It would be more accurate to speak of raising gasoline taxes rather than introducing them. If memory serves, taxation currently represents about 20-25% of the price at the pump in the US (varying slightly by state). This is certainly nowhere near European or Australian levels, but it’s not zero.


John Quiggin 09.15.04 at 1:25 pm

Mea culpa, Brian, I forgot about the difference between US and UK gallons. I’d suggest though that the PPP exchange rate is more like $1A= $US0.80, which would make the price $US3/gallon.

And of course, this only strengthens my point about elasticity of demand.


Ralph 09.15.04 at 1:57 pm

Metric miscalculations aside, what makes you think a $2 tax would lead to $4 gasoline? In 2010? Six years from now?

Mild suggestion: consult a sober petroleum analyst and ask what he and his friends think about the following little math problem:

$2 + $scary = $whatever


james 09.15.04 at 4:27 pm

What kind of negative impacts would this have on the US economy? Approx. 70% of all goods are shipped by truck. Not to mention goods shipped by plane. The increase in transportation costs would increase the costs of all goods. How much would this increase cost effect consumer spending?


son volt 09.15.04 at 5:38 pm

The part of the fuel tax that i would be passed on to consumers effectively would act, as a sales tax. But it’s a sales tax by the pound, not by the dollar. So bulky materials that come to the consumer in nearly raw form would be affected the worst (in the guess of this non-economist).

Back of the envelope calculation: A tractor-trailer with a 50,000 pound payload gets, optimistically, 8 miles to the gallon. Thus the truck hauls 25 tons 8 miles for $2 (less in TX, my neck of the woods). That’s a penny per ton-mile.

Doubling the cost of fuel would double the cost per ton-mile (ignoring substitutions like rail or greater operational efficiency). So to deliver a 1-ton car, which retails for $10000, 1000 miles, the additional cost due to the fuel tax would be $10. But the extra fuel cost would be the same to deliver a ton of rice, which retails for maybe $500.

So if all the increased transportation cost is borne by the consumer, then the price of rice goes up by 2%, but the cose of the car by only .01%.


james 09.15.04 at 6:18 pm

Perhaps this idea could be implemented to save social security?


WeSaferThemHealthier 09.15.04 at 8:10 pm

What % of oil is consumed by private cars ( as opposed to, say, lorries )?

While we’re speculating about unfeasible plans, why not a tax on private cars that is related to the fuel inefficiency of that car? You could reduce the amount of fuel used, raise money, encourage public transport, discourage urban sprawl and it wouldn’t have the same impact on shipping as what son volt described.

It would also hurt SUV drivers the most. Isn’t that a Good In Itself?


glory 09.15.04 at 9:11 pm

here’s brad setser’s take (and second ever post :)

In the first half of the year, net inflows of $200 billion from foreign central banks (a bit more than $100 billion in q1, a bit less in q2), and $175 billion from foreign private investors provided the $375 billion in financing the US needed. If this pattern of flows continues, the U.S. will be getting about $400 billion in net financing from foreign central banks for 2004. That is insane…

Foreign purchases of Treausuries are on a pace to more than finance the 04 fiscal deficit. At the end of the year, it looks like foreigners will hold more than $2 trillion in US government bonds, up from $1.5 trillion at the end of 2003. The U.S. truely has become every bit as dependent on foreign central banks to fund our deficits as it is on Saudi Arabia for oil! I would be a lot more comfortable if the US was exporting more goods and services and fewer treasury bills.

judging by the last auction it doesn’t look too good…

Indirect bidders, a group that includes foreign central banks, bought 2.9 percent of the amount sold, the lowest on record since the Treasury began providing such details in May 2003. Indirect bidders won 54.7 percent of the 10-year notes sold in August and 38.6 percent in June.

check out their paper on ‘The Sustainability of the US External Imbalances‘ :D cheers!


glory 09.15.04 at 9:21 pm

It would also hurt SUV drivers the most.

and people who buy these :D

in other news!


John Quiggin 09.15.04 at 10:08 pm

Ralph, I’m guesstimating that the reduction in global demand generated by a US tax will cancel out what would otherwise be a rising trend in prices.


Randolph Fritz 09.15.04 at 10:20 pm

“Approx. 70% of all goods are shipped by truck. Not to mention goods shipped by plane. The increase in transportation costs would increase the costs of all goods.”

Given time, ground freight would be shifted to using the rails. Air freight is a very small part of shipping.

The long-term outcome is probably going to be the collapse of the dollar on international currency markets, leading to multiple major global currencies.


John Quiggin 09.15.04 at 10:44 pm

Glory, thanks for the Roubini and Setser reference. I’m pleased to see that their detailed analysis matches my back-of-the-envelope almost perfectly.


Giles 09.15.04 at 11:04 pm

Other major objections; as I understand it, by 2010 the production of the US in oil is likely to have fallen even further.

Second round effects might include a widening of the deficit in cars since foreign producers are better at producing fuel efficient cars than the US.

Thirdly, as the US has a more dispersed population than Australia, I expect the output elasticity is going to be much higher.


self 09.16.04 at 12:04 am

Thanks from me as well, the Setser link looks worth checking frequently.


self 09.16.04 at 12:21 am

By the way, I noticed John’s comment about the US shortening the terms of its borrowing on Setser’s site. Is this a reflection of foreign central banks preferences or the US central bank preferences?

I recall this being a topic covered in Greenspan’s recent testimony (House, I believe). His point was that if FCBs were to start selling they comprise a small overall percentage of short-term notes so not to worry. How does this play into concern about vulnerability to changes in sentiment ?


self 09.16.04 at 1:43 am

Let me clarify the questions above.
Does the increased sales of shorter term securities reflect FCB preferences consistent with segmentation theory of term structure ? The point being that’s where the money is.

Or is the shortening of borrowing terms reflecting a more activist strategy of Fed borrowing consistent with statements by Bernanke earlier this year ?

And does the concentration of FCBs with such preferences in short-term securities tilt the vulnerability to sentiment reversals one way or the other ?


John Quiggin 09.16.04 at 1:44 am

“As the US has a more dispersed population than Australia”

This would make a nice topic in itself. In terms of population per square kilometre, the reverse is true by a factor close to 10. But the US population is much more evenly spread across the country than the Australian.


Alex 09.16.04 at 3:57 am

Very, very good discussion.
Again, please over several weeks time. I agree with raising price of oil & gasoline re usage in this country.

Many here are smart. One principle I have been thinking about (for long enough for attribution to me).
U.S. should demand x% factor(when certain countries are buying our treasures and paper) as a form of Tribute money for providing military protection to those several countries. Seems to me fools to be following old theories for too long and not adapting, while allowing those same several countries to screw us over re trade practices. (You’re also dreaming if think there is really free trade, invisible hand, rational choices, etc. with those certain countries and their markets have been open to this country.


Alex 09.16.04 at 5:20 am

My other thinking about some feasible solutions is not as much out of the box.


Matthew2 09.16.04 at 10:33 am


Giles 09.16.04 at 7:20 pm

“But the US population is much more evenly spread across the country than the Australian.”

More specifically the Australian population is more urbanized than the US and so better able to make use of public transport.

So given that Australian petrol consumption should then be more elastic than the US and given that the ratio of external debt to exports for Australia is higher than the US – shouldn’t it be Australia imposing a higher petrol tax?


John Quiggin 09.17.04 at 12:43 am

Australia’s population is best described as suburbanised – more like LA than NY.

On debt/exports, Australia is high but relatively stable, US is moderate but climbing fast. Both are vulnerable to a shift in sentiment.


Alex 09.17.04 at 6:46 pm

Too academic-oriented and right brain oriented I guess to have much real world experiences and real smarts here.


Giles 09.17.04 at 11:35 pm

“more like LA than NY”

Interstingly that more a description of style.

The greater LA population density is 6,000 vs New Yorks 4,000 per square mile. Australia varies from 4,000 for Sydney to 2,500. In fact there aren’t any Euorpean level compact cities in the US or Australia (London is about 15,000 – and Hong Kong ten times that!)


Ian Whitchurch 09.18.04 at 12:31 am

I’m not sure that a, say, 10% US fall in demand would do that much to the stress world oil is under.

The guy to read on this is Matthew Simmons btw … he’s a Texas Republican, sat on the infamous Bush Energy Task force, and he thinks the era of Cheap Oil is over.

On the supply side, we have a number of big fields in decline, notably the North Sea and Prudhoe Bay.

I think the new licence round in the North Sea will help, as the Juniors actually drill stuff, as opposed to whine about depreciation allowances … the model is the South Australian governments’ forced divestiture of the Cooper Basin exploration coutry by Santos, which is reversing the oil production decline curve of the Cooper even as we speak.

It wont last though … much as I like Worrior, Christies and Arwon, Tirrawarra they aint, and that will be the North Sea experience as well – some small to medium sized new fields, but all the giants around there have been found.

Daquing is a worry as well … it’s China’s biggest field at about a million barrels a day (thats over 1% of world production) and the local engineers were signalling a 7% production fall each year for 7 years. A CNOC VP then got sent out, and he is saying ‘No production decline ! Norms will be met !’.

Plug “china daily daqing production” into Google and you can watch the change in line.

Stressing a field by overproduction leads to lower total recoverable reserves btw.

Then there’s Ghawar, which delivers 4 million barrels a day. They’ve been pumping seawater into it for 20 years, and sooner or later they’ll stop getting oil and start getting seawater back.

On the demand side, it’s being driven by China, India and Indonesia.

A hint to the future is the rise in absolute and per-capita South Korean oil demand in the 1980s.

Mrs Chen now has an air conditioner, Liu the peasant a moped to take his chickens to market, and Han the factory worker has just bought his first car.

All this creates oil demand directly, and indirectly as increased electrical power demand leads to brownouts, which leads to factory owners buying diesel generators to provide power when the grid goes down.

I’m expecting total Chinese and Indian oil demand to continue to increase by 1 mmbo per day per year.

In the face of that, a US fall from 20 mmbo/day to 18 mmbo/day just compensates for 2 years worth of Chinese/Indian demand increase.

Me ? I’m putting together an oil company to work up a Cambrian basin that looks a lot like East Siberia, except it’s smaller and lacks the pine trees and permafrost :)

Ian Whitchurch

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