Why Are Gas Prices So High?

Perhaps the better question would be why aren’t gas prices rising.  With rising tensions in Iran and Syria, investors speculating in the oil market, increased demand in developing countries, and my personal favorite Obama rejecting the Keystone Pipeline, there is enough blame to go around.  But do these media driven narratives tell the whole story?  Gas prices have been north of $3.00 per gallon since February of 2011, so the tensions in the Middle East seem unlikely as do the speculators because they can only push up prices in the very short term since actual supply and demand determine prices after their initial speculations.  Obama rejecting the pipeline very well could have prevented prices from falling or stabilizing in the longer run, yet fails to explain why prices have been continuously climbing.   The increased demand from developing economies such as China, Brazil, and others certainly has had some effect on the price at the pump, but not nearly large enough to bring a gallon of gasoline from $1.90 in March of 2009 to over $3.75 today, March 2012.  If we cannot blame Muslims, Wall Street, China, and Obama’s energy policy then where do we go with our pitchforks and angry signs?  We can start with the Federal Reserve and Chairman Ben Bernanke, whose money printing, which he calls Quantitative Easing (QE), has devalued every dollar in your pocket and bank account while driving gas prices through the roof.

            Whenever I mention Quantitative Easing and the easy credit that the Federal Reserve has extended by lowering interest rates to 0% as the culprit behind rising gas prices, I usually get blank stares or profanity shouted my way.  The complex relationship between monetary expansion and rising prices, some will argue, is not exact and an increased supply of money need not lead to price inflation.    In other words if the Fed Chairman Ben Bernanke fires up the printing press and increases the money supply by 5%, prices will not increase by 5% uniformly across the economy and sometimes prices may not even increase at all; that is until the increased quantity of money and credit is realized.  That’s probably enough economic jargon for now, perhaps a simple illustration of such a relationship in a more familiar setting will sort out the confusion.


                Imagine a school lunchroom, where the students use school printed and distributed lunch tickets to purchase their meals, drinks, and snacks.  To make this scenario more plausible, we also have to imagine that the tickets are distributed to the students based on in class test performance, with students earning higher grades receiving more tickets.  For simplicity, our school only has three items for purchase each requiring one ticket; pizza, Capri Sun juice packs, and Mrs. Fields cookies.  After weeks of eating just pizza, the students grow sick and tired of the same old nutrition deficient slices and start bringing their meals from home.  However, they continue to use their tickets for the Capri Suns and cookies at their normal rate.  Once the principal hears of the lack of demand for pizza, he misdiagnoses the problem and comes up with what he believes is a solution to the problem.  If the school starts printing more tickets, he says, then the students will have more to spend on pizza and there will no longer be any left to throw out at the end of the day.   So the school turns on the printing presses and out come brand new tickets that they hand out to the students accordingly.  Now theoretically if all the students get their new tickets and decide that they should save them for a day when they are really need them, the prices for our three menu items should remain unchanged.  In reality though, most of these school aged children are going to run to the cafeteria as fast as their little legs can take them to get their hands on all of the Mrs. Fields cookies they can; a sure joy for their teacher who must control a sugar rushed class in the afternoon.

            At this point, the new tickets in circulation have been realized, that is the new tickets have been used.  With greater tickets chasing the same amount of food, the cafeteria will run out of food and drink for the less fleet footed kids in the back of the line, therefore they must readjust the ticket price of pizza, Capri Suns, and Mrs. Fields cookies by taking the additional supply of tickets into consideration.  So the next day when the students enter the cafeteria for lunch, in order to buy one slice, one juice pack, or one cookie they have to fork over 2 tickets.    The principal continues to print the lunch tickets as prices come into balance with the amount of tickets in circulation and the lack of demand for pizza resurfaces.  An important point to recognize, inflation is the increase in the supply of tickets and the subsequent price increases are merely symptoms of that inflation not the cause.

            A few students start to wise up and realize that the tickets they are holding on to are losing value relative to the items they can purchase, or said differently, the items they purchase are gaining in value relative to tickets.  Acting in their rational self-interest they start buying up all the Capri Suns and cookies they can, since pizza perishes, because they realize the creation of new tickets will continue to push the price up, so they speculate that their investment now in Capri Suns and packages Mrs. Fields cookies will bring them a future return.  These students become the speculators.

            Other students feel no necessity to use their new tickets on items they do no currently want to consume and simply save them for future use.  By not speculating and being prudent enough to save their tickets, these students put themselves at a disadvantage when prices inevitably rise from the continued money printing.  They very well could blame the other students who speculated in the juice packs and cookies or the cafeteria for raising prices, but the reason prices rose and savers had the value of their tickets erased is simply because more tickets were created out of thin air.

            Now back to reality.  Our real economy is obviously much more complex than a school cafeteria, but the principles and laws behind tickets and dollars are essentially the same.  The $2.6 trillion created out of thin air by the Federal Reserve as a part of the Quantitative Easing (QE) programs to stimulate demand in the economy have increased gas prices, and all prices for that matter, in the same way that ticket printing in our cafeteria brought up the price of Capri Suns.  To put in perspective how enormous even one trillion is, consider this — 1 trillion seconds ago the Bible had not yet been written and the Pyramids at Giza had not yet been built. Credit expansion, through lower than market interest rates, creates similar upward pressure on prices the way money printing does and does so more deceptively.  Any politician whom openly clamors about rising gas prices and attributes it to tensions in Iran, failed domestic energy policies, or speculators and then promise legislation to bring back $2 per gallon gasoline can only hope to stop price increases if the creation of new money and the expansion of credit are both halted.  In the meantime, barring some drastic oil supply increase, gas prices will continue their steady climb, but at least now we understand why.

            After a length and friendly debate with one of my professors on the issue of speculators, I feel as though it is important to discuss it further.  Recall our school cafeteria and our ticket-printing principal who created speculators by his obsession with the printing press.  Even with such an example, many still argue that it is indeed the speculators driving up the price by aiming to hoard the Capri Suns and Mrs. Field’s Cookies.  It is certainly true that without speculators spending their tickets with no desire to consume, the increase in the supply of tickets may never be realized and prices may never rise.  Yet we must look at the root cause of what facilitates such speculation and seemingly useless purchases to take place, and that is the initial increase in the supply of tickets circulating the lunchroom.  These speculators actually provide a valuable service to the rest of the student body; say a particular student invests in a Capri Sun juice pack at a cost of 2 tickets and prices keep rising to 6 tickets.  The speculator can then turn around and sell his Capri Sun profitably at 5 tickets to a buyer who is saved 1 ticket in the process.

            So is the case with oil.  The commodity futures markets, again, are certainly more complex than this micro example.  However there are two key points to be made; first the speculators had to get the funds to speculate from some source, in the cafeteria it was the ticket printing champion principal and in the United States it was money printing champion Chairman of the Federal Reserve Ben Bernanke.  Second, in a world of rising prices that cause utter uncertainty for business owners, speculators provide a valuable service by providing price and quantity certainty for clearer planning.  So don’t blame the speculators, blame the money masters at the Federal Reserve.

Article by Steven Prescott.
Illustrations by Dan Herczak.


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