How Two Nobel Prize-Winning Economists Got Oil Wrong

  • Date: 15/06/17
  • Michael Lynch , Forbes

My recent book details the numerous mistakes made by many experts — real and apparent — about the oil market and oil prices.

 

This post will point to two in particular (the latter of which did not appear in the book).  Robert Solow and Paul Krugman are both M.I.T. professors of economics (Krugman only for a time) and Nobel Prize winners in economics.  I had an undergraduate course with the former, and very minor contact with both over the years (neither of whom is likely to remember me) and consider them to be scholars and gentlemen.

Which doesn’t mean they haven’t been seriously wrong about petroleum economics in ways that are instructive to us all (in theory; in practice, I’m not so optimistic about our ability to learn). The former allowed himself to be blinded by math, the latter more by ideology, but both fall prey to what Tom Nichols (author of the excellent book The Death of Expertise) calls “stretch[ing] their expertise from one area to another.”

To the WABAC machine, Sherman. December 1973, the American Economic Association is holding its annual meeting in Boston, its members spread out across a number of hotels (and a larger number of bars).  The October/Ramadan war between Israel and Egypt and Syria (primarily) had broken out two months earlier, and OAPEC (not OPEC) declared an oil embargo (the second, not first) and cut production by 4 million barrels a day, at the same time that some of their negotiators were meeting with the operating companies in Vienna to demand higher tax payments.

Not surprisingly, given the tight oil market at that time, oil prices shot up, roughly tripling in a few months. By the time of the AEA meeting, the first Oil Crisis had begun and naturally was an object of attention. Two speakers in particular are of interest here, one a young Robert Solow, who promoted what came to be known as the Hotelling Theory, an interpretation of a 1931 article by Harold Hotelling. Briefly, it could be shown mathematically that mineral prices should rise exponentially over time. Later, other economists would argue oil prices in particular should rise at the rate of interest, roughly 3% per year above inflation.

The figure below, showing oil prices up to 1972, should immediately have thrown this into question. There is obviously no such trend as the Hotelling theory would predict. Indeed, quite a lot of work has been done to show that mineral and energy prices do not have historical trend towards rising prices. Indeed, this was the subject of a famous wager between Julian Simon and Paul Ehrlich, which Ehrlich lost badly (and foolishly, betting on rising prices after a period of rapid inflation).

Oil Price in 2015$Author from BP data.

Oil Price in 2015$

Now, it is true that oil prices had not been governed by a free market through most of the period before 1973, which can could be a rationalization for the theory’s failure, although not as much for prices of metals, for example. What might be more troublesome is that another M.I.T. economist, M. A. Adelman (my friend and mentor) also spoke at the 1973 AEA meeting and he was a resource economist, who had the previous year published The World Petroleum Market, a data-heavy exploration of petroleum economics. He ascribed the price increase to the production cutbacks.

Which view prevailed? Neither at first, especially since the market began to weaken after 1974. However, as a chorus of voices were raised to say that oil markets would tighten again and prices renew their upward march (see chapter 2 of my book), the onset of the Iranian Revolution, when prices soared again, the consensus somehow interpreted the effect of a 6 million barrel per day supply disruption as unimportant and argued rising prices were due to resource scarcity. The Solow interpretation of Hotelling dominated the oligopoly view of Adelman.

Fast forward to the peak oil “crisis” of the 2000s and our second economist, then Princeton professor Paul Krugman, is a columnist for The New York Times and as such, presumably felt compelled to talk about the high oil prices in 2008 and the peak oil theories. And he gets both completely wrong.

In a May 12, 2008 column, Krugman pooh-poohed the idea that speculation was driving the oil price (then at $125 a barrel), saying:  “all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China.”

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