Journal Issue
Finance & Development, March 2015

Book Reviews

International Monetary Fund. External Relations Dept.
Published Date:
February 2015
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Rock and Roil

Blake C. Clayton

Market Madness

A Century of Oil Panics, Crises, and Crashes

Oxford University Press, New York, 2015, 248 pp., $27.95 (cloth).

Ever since Thomas Malthus’s Essay on the Principle of Population was published in 1798, people have worried that limited availability of natural resources could constrain economic growth and human welfare. For nonrenewable natural resources (for example, fossil fuels such as oil, natural gas, and coal), Malthusian concerns center around depletion.

So far, such fears have not materialized. Growing and substantial evidence suggests a downward trend in real commodity prices, despite exponential growth in the production of nonrenewable commodities. Nevertheless, fears about resource shortages—including of crude oil—tend to surface regularly when prices increase above trend.

We may be witnessing the end of yet another episode of widespread fear of oil depletion. Predictions that global oil production would peak attracted broad attention when oil prices reached new highs in the early 2000s, but have since subsided thanks to the shale revolution in North America and the halving of oil prices in late 2014.

In Market Madness, Blake Clayton, now an economist with Citibank and formerly a fellow on energy at the Council on Foreign Relations, analyzes four episodes of growing fear about oil depletion through the lens of “irrational anxiety”—an allusion to Irrational Exuberance, Robert Shiller’s famous book on equity and housing markets. Clayton’s premise is that some of the social, cultural, and psychological factors behind irrational exuberance also apply to irrational anxiety.

Clayton focuses on one of Shiller’s arguments—that speculative market expansions in equity and housing often accompany popular perceptions that the future is brighter or less uncertain than it used to be. In oil markets, steadily rising prices have triggered fears of shortages, based on variations of the argument that there is limited oil still in the ground and that prices must rise forever to balance demand and supply.

The specifics vary across the four episodes Clayton examines, spanning the 20th and early 21st centuries, but there are common elements. For example, in the first, 1909–27, oil demand increased rapidly with the dominance of the internal combustion engine in transportation and the development of the petrochemical industry. World War I reinforced the increase in demand. A 1909 study of the total volume of crude oil reserves in the United States by the U.S. Geological Survey concluded that these reserves would be exhausted by 1935. The study acknowledged the possibility of new oil field discoveries but considered them unlikely. This would not be the last time that both the economically variable amount of oil in known fields and the scope for new discoveries and technological advances were grossly underestimated.

During the first episode, predicted structural shifts in the market did not materialize. Peak-oil theorists, for example, argued that about half of all below-ground oil resources had already been used and that decline in production was inevitable. But the likely oil resource base continued to increase. The second episode brought predictions of forever-increasing prices due to actual structural shifts. During the third episode—the era of the Organization of the Petroleum Exporting Countries (OPEC) in the 1970s and 1980s—it was widely assumed that OPEC’s market power was such that oil prices would continue to increase. But that market power has varied over time with the entry of other producers and shifts in demand.

Since oil is storable, it is a real asset.

Remarkably, Clayton does not follow Shiller’s journey to the end. He does not consider the possible link between irrational anxiety and price increases or the possibility of oil price bubbles. Neglecting this link for the early episodes might not be a problem, given prevailing price-setting mechanisms and government intervention (for example, during wartime). Instead, Clayton argues that oil anxiety perpetuators sometimes had political motives, seeking to influence government policies affecting the oil market. But in the final episode, between 1998 and 2013, oil price formation took place in spot markets, and the market for oil derivatives expanded rapidly. Since oil is storable, it is a real asset, and the link between irrational anxiety and price formation during these episodes merits more discussion.

The first two episodes are mostly U.S. specific, which is understandable because markets were then less internationally integrated. Still, readers interested in oil issues will find the account of these episodes intriguing—especially the first, which examines the rise of the conservation movement in the United States and elsewhere.

Thomas Helbling

Chief of World Economic

Studies Division, IMF Research Department

Six Degrees of Devastation

Gernot Wagner and Martin L. Weitzman

Climate Shock

The Economic Consequences of a Hotter Planet

Princeton University Press, Princeton, New Jersey, 2015, 264 pp., $27.95 (cloth).

This informative, convincing, and easily read book offers general audiences the basic case for global climate mitigation.

Climate Shock points out that the most pressing reason for action on climate mitigation is the possibility of catastrophic outcomes, most importantly a 10 percent risk of a 6 degree Celsius temperature rise unless measures are taken in this century. It argues that carbon pricing should take center stage in mitigation efforts but warns of challenges, not the least of which is free riding (individual countries’ temptation to avoid mitigation given that all countries bear the costs of global climate change). Without mitigation efforts, individual countries may resort to inexpensive geo-engineering—for example, releasing sulfur particles into the atmosphere to deflect sunlight—which entails huge risks, including altered global precipitation patterns, while failing to address threats to the marine food chain from ocean acidification.

The case for carbon pricing—charging for the carbon dioxide (CO2) emissions caused by fuel combustion—is well established: emission prices are reflected in the prices of carbon-intensive fuels, electricity, and other forms of energy, which presents a full range of mitigation opportunities. These include switching from coal to natural gas or renewable fuels and reducing demand for electricity, transportation, and heating fuels. But unless carbon pricing revenues are used productively—for fiscal consolidation, broader tax cuts on worker income, capital accumulation, and so forth—carbon pricing can impose a large cost on an economy.

The authors do not get into the debate over carbon taxes versus emissions trading systems (through which governments limit rights to pollute by issuing a fixed amount of allowances that firms can trade), though in my view the latter are more convoluted (implying, perhaps, greater risk of key design flaws). Emissions price stability—necessary for cost effectiveness from year to year and to promote incentives for clean technology investments—is automatic under a tax, but under an emissions trading system requires additional measures, such as price floors and ceilings. And in emissions trading systems, allowances must be auctioned and revenues remitted to the finance ministry, if carbon pricing is to be part of broader fiscal reform.

The authors suggest that some current estimates of an emissions price that reflects future climate change damages—about $40 a ton of CO2—are much too low, because of problems in modeling extreme climate risks and long-range discounting. But the concern seems of little practical relevance now, given that only about 12 percent of global emissions are currently priced, typically at about $10 a ton or less.

The free rider issue has caused much agonizing in international climate negotiations over enforcing countries’ mitigation pledges and appropriate compensation for mitigation in poorer countries. But the problem may be a bit overblown: carbon pricing can actually be in a country’s own interest if the domestic environment benefits—for example, because of fewer deaths from local air pollution arising from fossil fuel combustion—outweigh mitigation costs. IMF estimates suggest that, averaged across large emitting countries, these benefits warrant CO2 prices of about $57 a ton before counting in global warming benefits.

There may be other reasons to be a bit more optimistic than the authors about the prospects for carbon pricing. New revenues are attractive to finance ministries seeking to cut other taxes, meet consolidation needs in the wake of the fiscal crisis, or fund public services in countries whose large informal sectors constrain broader tax bases. And carbon pricing can entail a straightforward extension of what most finance ministries are already doing: it can build a carbon charge into existing motor fuel excises and apply similar charges to the supply of other petroleum products, coal, and natural gas. More quantitative analysis of the environmental, fiscal, health, and other benefits of carbon pricing at the country level is needed to help governments make the case for carbon pricing to legislators and the public.

The book could have elaborated a bit on measures needed to accompany carbon pricing. For example, instruments (varying with country circumstances) need to be designed to mitigate impacts on vulnerable households and firms. Clean technology incentives also have a role, but guidance is needed on which instruments to use and how to set their level and phase them out as new technologies mature. And at an international level the practicalities of monitoring and enforcing agreements (for example, regarding carbon tax floors among large emitters) that can complement the UN process must be fleshed out.

While this book lays the basic intellectual groundwork, there is more to be done in thinking through the practicalities of moving carbon pricing forward.

Ian Parry

Principal Environmental

Fiscal Policy Expert, IMF Fiscal Affairs Department

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