Podcast Summary: Oil Shocks, Price Controls, and War

The Marginal Revolution Podcast – Mercatus Center at George Mason University
Hosts: Alex Tabarrok (A), Tyler Cowen (B)
Date: October 22, 2024

Overview

In this episode, Alex Tabarrok and Tyler Cowen explore the turbulent economic era of the 1970s, focusing on the consequences of the oil shocks, the policy responses—namely price controls—and their far-reaching impacts. The discussion weaves through the causes of the energy crises, their effect on macroeconomic stability, the puzzling mechanisms behind economic downturns triggered by resource shocks, and how these events shaped the economic landscape and policy thinking of subsequent decades.

Key Discussion Points and Insights

1. The “Golden Age” of Stable Oil Prices

• Oil Price Stability: From 1950 to the early 1970s, oil prices remained impressively stable—largely due to spare production capacity controlled by entities like the Texas Railroad Commission and the major oil companies known as the "Seven Sisters."
  • Alex: “The price was stable, was so stable, absolutely flat, for two reasons... there was lots of spare production... [used] to keep prices stable, particularly the United States, led by the Texas Railroad Commission...” [00:45]
• Focus on Quantity, Not Price: Oil-producing countries, like Iran under the Shah, were more concerned with boosting output rather than haggling over price since revenues were thought to come from quantity increases.
  • Alex: “The focus during the 1960s and 1970s was all on increasing quantity. And there was very little hint that the demand for oil might be very inelastic.” [01:58]

2. The Oil Shocks: Sudden Disruption and Overlooked Elasticities

• The Shock: Oil prices tripled between mid-1973 and early 1974, a startling shift after decades of flat prices. The world realized only then how inelastic oil demand truly was.
  • Alex quoting Daniel Yergin: “America’s spare capacity had proved to be the single most important element in the energy security margin of the Western world... and now that margin was gone.” [07:05]
  • Alex: “Almost accidentally, the exporting countries had discovered that the demand for oil was more inelastic than anyone had ever realized.” [08:24]

Notable Moment

• Sheikh Ahmed Yamani, Saudi oil minister, upon gaining leverage over prices:
  • Alex: “This is a moment for which I have been waiting for a long time. The moment has come for we are masters of our own commodity.” [07:55]

3. Was the Oil Shock “Good” in the Long Run?

• Energy Independence and Innovation Arguments: Tyler asks if the turmoil of the 1970s eventually benefited the US by forcing innovation and shifting towards energy independence.
  • Tyler: “Through a long, awkward, stupid process, it did lead to the US becoming... energy independent. Was it on net a good thing that we had those oil price shocks?” [02:29]
• Alex's Counterpoint: The disruptive and chaotic nature of the shocks prompted bad policy, not just beneficial adaptation. The period led to dampened optimism toward growth, a stalling of nuclear investment due to the Three Mile Island accident, and a general malaise in attitudes toward technological progress.
  • Alex: “The craziness... actually worked in a negative direction. When you have a lot of volatility, a lot of craziness, people have bad ideas.” [03:48]
  • Alex: “We really went into a backwards period, in my view.” [04:13]

4. Policy Responses: Price Controls and Misallocation

• Widespread Price Controls: Nixon’s administration imposed economy-wide price controls in 1971, and specific controls on oil and gas persisted long after.
  • Alex: “Nixon imposes price controls. This is August 15th of 1971... he puts a price freeze on all prices and wages in the United States... the public loved it.” [20:43]
• Unintended Consequences: These controls led to shortages, misallocations, and bizarre market distortions, such as different prices for "old oil" vs. "new oil."
  • Alex: “It’s amazing... price controls create shortages. But the surprising thing is they also create these surpluses... you had parts of the United States which were dying literally for not having heating oil. At the same time, you had lots of heating oil in other parts.” [25:07]
  • Alex: “A price is a signal wrapped up in incentive.” [26:41]
• Complex Regulations: The government further complicated matters by devising multiple prices based on oil’s origin or age, which only worsened misallocation and confusion.
  • Alex: “Old oil was under a price control, but new oil... didn’t have a price control... You had now two different prices for the same goods.” [27:39]

Memorable Segment

• Lines at gas stations and Christmas sacrifices:
  • Tyler: “The deadweight loss I remember best was just waiting in the car... very long lines... once a week.” [29:26]
  • Alex: “Right, right. Absolutely. And often you’re running your car in line waiting..." [29:40]
  • Tyler: “That year, the Grinch stole Christmas. I was living in northern New Jersey... the lights were not out was a big deal. That was just gone all of a sudden.” [29:47]

5. The Macroeconomic Puzzle: Why Did Small Oil Shocks Cause Big Recessions?

• Sectoral Shocks vs. Large Downturns: Theorists expected only minor output loss from energy price hikes but observed sharp recessions.
  • Alex: “Most of our listeners will say, well, what’s puzzling about that? Price of oil goes up and you go into a recession... And yet for economists, this is still quite puzzling.” [12:15]
  • Alex: “There are pretty sophisticated theorems which say that if you have... a shock to a sector... the effect should just be... half a percent on GDP.” [13:11]
• Explaining the Shortfall: Tyler and Alex point to uncertainty, the pervasive input nature of energy, and both economic and geopolitical shocks (including the specter of nuclear war and the effect on expectations).
  • Tyler: “When it’s something that’s an input into many goods and you have indivisibilities... you’re courting much larger risks.” [14:22]
  • Alex: “The war itself... created a lot of uncertainty because the Arab countries were being backed by the Soviet Union.” [15:16]

6. Broader Consequences: Political, Cultural, and Geopolitical Reverberations

• Global and Domestic Unraveling: The period saw not just an oil crisis, but also events like Watergate, the Yom Kippur War, and a widespread sense of uncertainty.
  • Alex (quoting Daniel Yergin): “Too much seemed to be happening. The media and the public mind were overloaded. Who could imagine such a thing?” [17:22]
• Unexpected Outcomes: The oil windfall contributed to the destabilization and revolution in Iran, illustrating the perils of sudden "free money."
  • Alex: “One of the causes of the Iranian revolution was the huge success of the Shah... this $8 trillion is whipping its way through the economy is incredibly disruptive.” [32:17]
• Oil Price Volatility and the Soviet Union: Tyler posits that swinging oil prices contributed to the collapse of the USSR by undermining their resource-dependent economy.
  • Tyler: “The great achievement of the 20th century... bankrupting the Soviet Union, came about through this dynamic.” [10:12]
  • Alex: “Isn’t the usual story that Russia... the high price actually maintained the Soviet Union?...” [10:42]

7. Lessons Learned (and Forgotten)

• The Case for Market Signals: Ultimately, removing price controls (e.g., under Reagan in 1981) swiftly ended shortages and set the stage for the US energy resurgence.
  • Alex: “He decontrols the price on Inauguration Day... shortages ended immediately... The resurgence of American production would not have happened without Reagan’s decontrol of oil prices.” [36:42]
• Modern Parallels and Evolving Policy: Germany’s adaptation to the 2022 Russian gas cut-off demonstrated a more market-oriented and effective response, using lump sum transfers rather than controls.
  • Alex: “German economy adapted to... much lower supply of natural gas by using less and finding substitutes... spot price rose... but [government] let the price rise... and the German economy rode out this massive decline.” [41:05]
  • Tyler: “I was shocked that went as well as it did.” [42:32]
• Forgetting Hard-Won Economics: The 1970s fostered a generation that valued clear market signals and skepticism of interventionism, but these lessons may be drifting from public consciousness.
  • Alex: “Milton Friedman was right on the greatest number of things... because he was lucky enough... to come to fruition at a time where we were doing everything wrong.” [44:37]
  • Tyler: “The 1970s was a great time to learn economics. The lessons were very visible.” [44:31]
  • Alex: “They forget... what caused Milton Friedman to come into being, which is all of the mistakes which we made in the 1970s.” [44:00]

Notable Quotes and Memorable Moments

• On market signals and price controls:
  “A price is a signal wrapped up in incentive.” — Alex [26:41]

• On price controls and shortages:
  “Shortages started before the war, before the reduction in supply of oil, before the big increase in the price of oil... the shortages were caused by the price controls.” — Alex [22:36]

• On the aftermath of the shocks:
  “Thirty years later, they’re going to turn it [Three Mile Island] back on... If the price of oil is going up, you should be investing more in nuclear. Right? But we got an environmental movement that put all energy sources under pressure.” — Alex [04:17]

• On the great forgetting:
  “Milton Friedman's been dead for some time... People forget... what caused Milton Friedman to come into being, which is all of the mistakes which we made in the 1970s.” — Alex [44:00]

Timestamps of Important Segments

• The stability of oil prices and the system that maintained it: [00:00–02:29]
• Discussion of whether the oil shocks were 'worth it': [02:29–05:17]
• The rise of OPEC and the key realization about oil demand: [05:28–09:49]
• Oil, investment, and bankrupting the Soviet Union: [09:49–12:09]
• Macroeconomic puzzles and real business cycle theory: [12:09–16:14]
• The role of uncertainty and overlapping crises: [16:14–18:11]
• Policy responses: controls, shortages, and misallocation: [18:11–28:55]
• Consequences for Iran and global geopolitics: [30:43–35:09]
• Carbon taxes vs. price controls and energy czar hypotheticals: [35:09–39:34]
• Alternative energy timelines, nuclear and adaptation: [39:34–41:07]
• Modern example: Germany and Russian gas cutoff: [41:07–43:13]
• Forgetting economic lessons and the 1970s as an inflection point: [43:13–45:28]

Conclusion

Tabarrok and Cowen’s lively, nuanced discussion illuminates how the oil shocks of the 1970s transformed energy policy, macroeconomic thinking, and the political economy of price-setting. From the nuts and bolts of price misallocation to sweeping geopolitical consequences, this episode distills both the chaos and the unintended learning that shaped the modern economic consensus.

“The 1970s was a great time to learn economics. The lessons were very visible.” — Tyler [44:31]

“We’re doing these podcasts... [because] people forget. They forget the lessons.” — Alex [45:28]