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Low oil prices: good and bad news. And how to deal with the bad news

Author(s): Paul DeGrauwe

From Ivory Tower:

Since the start of the summer, crude oil prices have started a steep decline again. From more than $60 a barrel in June the crude oil price has dropped to approximately $42. One year ago the crude oil price exceeded $100 a barrel.  These are fantastic price declines rarely seen in the oil market. They have helped the many European Countries to climb out of the recession. This is not surprising. A price decline of this magnitude means that consumers who spend a significant part of their total budget on gasoline now find out that after filling their cars with fuel they have purchasing power left over to buy other things.

Put differently, the oil price decline is equivalent to a reduction in taxes. As a result, disposable income has increased. This effect has been strong enough to more than offset the austerity policies pursued in many European countries. It is responsible for the economic recovery that we have seen in most of Europe. Thus, it appears that the oil price decline is good news.

While the short-term effects of the oil price decline are positive, the long-term effects are not. One year ago crude oil prices stood above $100 a barrel. This created a powerful incentive to develop and expand the use of alternative sources of energy such a solar and wind energy. The latter had become profitable at such high oil prices. Today with low oil prices this may not be the case anymore in many countries.

In addition, low oil prices also have as a pernicious effect of making transportation by car, trucks and planes much cheaper again. As a result, this will give renewed incentives for excessive worldwide specialization intensifying the massive transportation of goods and commodities from one corner of the world to the other. This will increase the emission of CO2 and will further speed up the global warming.

Our conclusion therefore is that if the low oil prices are maintained the long-term effects for the world are very negative. These long-term negative effects most likely outweigh the positive business cycle effects experienced today.

How can this conflict between the short-term positive and long-term negative effects be solved? The economic answer is easy; the political one is difficult.

It would be easy for governments of the oil importing countries to solve this problem by raising taxes on fuel so as to keep gasoline prices at the level existing one year ago and to use the additional tax revenues to lower other taxes, e.g. personal income taxes. As a result, consumers would continue to enjoy a higher purchasing power. This higher purchasing power would not be the result of lower gasoline prices, but of lower income taxes.

Thus, such a tax shift (more fuel taxes and less income taxes) would make it possible to maintain the positive short-term effects on the business cycle, as consumers would have more money to spend. At the same time, because it keeps the fuel prices high for the users, it avoids all the negative long-term consequences of low oil prices for the environment. Simple, wouldn’t you think? Yes, but unfortunately the politics is more difficult.

The political problem arises from the fact that the higher fuel taxes that the governments have to introduce create many enemies. These are the car companies and the transportation industry. They all profit from the present low oil prices and are likely to resist any tax increase on fuel. In contrast consumers are mostly indifferent whether the increase in purchasing power comes about by lower gasoline prices or by lower income taxes. The net effect is that it will be difficult for governments to overcome the political resistance that will be organized by the car companies and the transportation industry.

The only way out of this political problem is through an opposing political force. Such an opposing force can come about when large segments of the population recognize that low oil prices increase the risk of global warming and that this can be stopped at little cost in terms of economic growth today.  Such a force can twist the arms of the politicians to act and to safeguard the interests of the general population, today and in the future.


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