The International Energy Agency’s (IEA) chief economist warned this week that rising oil prices are a threat to the nascent global economic recovery (FT). One of the foreign policy implications of resurgence in oil prices in coming years is that it will increase aid burdens on multilateral institutions that, like it or not, the US has to fund. A much more ominous consequence of the rising prices, however, is that it transfers money from the West into the foreign policy budgets of Russia, Iran, and Venezuela, key US adversaries. The no-end-in-sight rise in oil prices is largely a function of growing demand in China and India—but the United States is still the world’s largest consumer (and, ironically, one of its three largest producers; see excellent FT oil flows map). US demand fuels price increases.
Oil has been a part of foreign policy for decades. Daniel Yergin, my favorite oil expert, has written in detail about the development of the “oil weapon” in the foreign policy thinking of Arab states in the 1970s (Yergin’s definitive book is out in a brand new edition). The notion that a resource could achieve foreign policy outcomes that force could not was hard to accept for many, especially Saudi Arabia, but it has worked to their strategic advantage ever since. As part of a larger foreign policy strategy, the US could gain considerable strategic advantage by employing its own oil weapon: the Pigovian oil tax.
How it works
The US government announces a floor on gas prices—say, $3 per gallon—and a legislated commitment to raise that floor by, say, 50 cents every six months… forever (conservative pundit Charles Krauthammer suggested the moving floor idea). Basic economic theory teaches that owners of a finite resource—like oil—choose production quantities based on expectations of future demand. If producers expect demand to grow in the future, as they do now with US oil addiction and the continuing emergence of China and India, they will limit production now and save their resource to sell at higher prices later. If producers expect demand to decline in the future, they will increase production now, even at lower market prices, to get rid of their product before it loses value on declining demand. An announcement of a permanent, rising Pigovian tax in the United States would prompt producers to increase production now, and world oil prices would fall (though US gas prices would not). Government revenues would increase as oil prices fall—revenues that could pay off debt or, for political purposes, reduce income tax rates.
The primary benefit of this policy is that it gives markets powerful incentives to develop alternative energy through market methods. Once car companies know that gas will get rapidly expensive, they know they must produce more efficient cars (remember that Chevrolet fast-tracked the Volt when oil prices got high in 2008). Rather than letting Congress choose industries to subsidize (like corn ethanol or certain hybrid cars) based on political capture instead of viability, and rather than imposing arbitrary mileage standards (CAFE) on car production, markets find the best alternatives through Schumpeter’s “creative destruction.” A domestic result is structurally reduced emissions, which appeals to Left-leaning Americans concerned about global warming and environmental damage, which should please the Left. Another result would be reduced political demand for subsidies and mileage standards, which should please economic conservatives. A crucial outcome is the gradual but inevitable decoupling of the US economy from its destructive dependence on oil prices.
Foreign policy outcome
Several key US concerns—Venezuela, Russia, and Iran—are heavily dependent on high oil prices for their belligerent foreign policy ambitions and their domestic political legitimacy. Policies in these countries would have to change course immediately upon the introduction of the tax and the guarantee of lower world oil prices. Russian adventurism in Eurasia would be severely limited, and Putin’s hold on power would be threatened. Iran’s proliferation and maintenance of conventional forces would be restricted, and the hard-liners’ hold on power would be threatened. Chavez’s massive social programs which have guaranteed him political power, along with his subsidization of anti-Americanism in LatAm, would have to go, and his hold on power would be threatened. These results would change the game dramatically in Washington’s favor. It would finally give Washington desperately needed leverage in negotiations with hostile states which have gone nowhere in the last decade.
Like Saudi Arabia before the 1970s, the US will be reluctant to make such a calculated, interest-based policy with something as important as oil. Dominant ideological trends in the US are against the move, but in addition to a majority of economists, a rapidly growing number of pundits are voicing support for the idea. Reality-based policymaking requires acknowledging both opportunities and limitations of geostrategic conditions. While US oil dependence has been a serious limitation of US power in the past, the oil-revenue dependence of adversarial states provides a strategic opportunity for Washington. Ultimately, US policymakers have an obligation to protect this key US interest through pragmatic policy.
See also my old post on oil and foreign policy; The Oil Drum blog; and Greg Mankiw’s Pigou Club Manifesto
Real Diplomacy 