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  Newspaper editorials began attacking my involvement as soon as my op-ed first appeared. By late August, I learned that the Commissioner of Political Practices had come close to filing felony charges against me for ostensibly violating a law forbidding state employees from engaging in political campaigns. I had no idea that such a law even existed, but fortunately for me, I wasn’t on a state salary at the time because I was scheduled to go on leave at the Hoover Institution at Stanford University the following academic year. Learning of this, the commissioner’s office dropped its investigation of me. Curiously, no one threatened to prosecute the host of state-salaried academics and other state employees who were energetically campaigning against the initiative.

  During August, I also began hearing complaints about my activities from the Montana State University administration. The chairman of my department repeatedly told me that the dean didn’t want me to continue publicly advocating the initiative. But I continued my work anyway, helping Frank Adams, who had also become an official spokesman for the initiative, send out a flurry of press releases. Before I left for Hoover, I helped to convince several prominent Montana political figures to endorse the ballot measure.

  I left Montana in late August, but I agreed to remain a spokesman for the initiative and to return to the state in September and October to participate in several televised debates. When I first came back on September 19, I found my colleagues in the Economics Department in a state of panic. Several faculty members hollered at me that I was destroying the department because the university was going to punish it for my involvement in the initiative. I learned from the department chairman that there really was some truth to this—the university president and other administrators were calling him and threatening to cut the department’s funding if it did not get me to “shut up.”

  On September 22, the day of my first TV debate, I spent a few hours in the chairman’s office listening to him describe the threats that my actions were posing to the department. He told me that while my analysis of the effects of property taxes was economically sound, it was best not to say anything about such a sensitive topic. I reluctantly agreed to skip that night’s debate, for which a local businessman filled in for me. Ironically, his opponent was a political science professor from the University of Montana.

  I returned to Hoover, but over the next few weeks I continued talking to the press about the real economic implications of cutting property taxes. I flew back to Montana on October 9 to participate in a debate that evening with some state senators. When I arrived in Bozeman the next morning, I found the department chairman in a state of near-apoplexy. He demanded to know if I had really stated during the debate that public school teachers were overpaid. When I told him that I had, he related how incredibly upset the dean was, and that he was unsure what the consequences would be. Given the pressure facing the department, I went back to Hoover and refrained from scheduling any additional appearances in Montana.

  Constitutional Initiative 27, which would have abolished property taxes in Montana, was defeated on November 4, receiving 46 percent of the vote. However, we took some measure of consolation that a parallel measure designed to freeze property taxes, Initiative 105, passed by a comfortable margin.

  Things didn’t quiet down for me after the campaign ended. In the department evaluations conducted at Bozeman at the beginning of 1987, I received the department’s lowest ranking in the category of “outreach,” which deals with communicating with the nonacademic community. On a zero to four scale, with zero being the lowest score, I got the department’s only zero. I’m typically not overly concerned with that ranking, since I usually concentrate more on my teaching, research, and publications. However, given that my high-profile activities in support of Initiative 27 had made me one of the best known economists in the state and, more importantly, my research had gotten some national attention, I was a little surprised. The ranking was obviously a form of punishment for my politically incorrect activities supporting the abolition of property taxes.

  As a final bit of collective punishment, I was told that the method used to rank the department relative to other departments had been changed. The new method would likely end the department’s ranking as the best department in the School of Agriculture, an event that could result in a cut in department funds. The chairman told me that the dean would consider returning to the old method if department members—especially me—behaved themselves in the future. The administration was particularly concerned over reports that there would soon be another ballot initiative on property taxes. The chairman asked me to promise not to talk to the press anymore about the issue. I declined, arguing that if the press were to publish more misleading statistics and I were asked about them, I would feel obligated to set them straight.

  Perhaps I had been naïve, but I was surprised by the vehemence with which people who receive their income from taxes fought to protect that largesse. While administrators at Montana State University would constantly extol academic freedom, they would not let something that trivial prevent them from doing whatever they believed necessary to protect their jobs. The experience convinced me that there’s an inherent inconsistency between publicly provided education and academic freedom. Even when people do not try to silence dissent as overtly as my former colleagues did, the fact that professors and administrators receive their income from taxes cannot help but color their opinions on issues touching on the free market or the size of government.

  Learning by Doing

  Aside from concerns over their own salaries and jobs, there is another reason why so many academics are skeptical of the free market: too many of them spend their whole lives in academia. Many go straight from college to graduate school and then spend the rest of their lives teaching in the ivory towers, where their output is primarily evaluated by other academics. Academia is about the only profession that consumes its own output. It’s as if car companies limited their auto sales to employees of other car companies. This tendency keeps academics too concentrated on theory and not enough on real world practicalities. Think about it: academic research about how an industry operates is refereed by other academics. Neither the author nor the referees may have had any actual experience in the industry.

  I have spent much of my own career in academia, but one of my most educational experiences was my service as the chief economist at the United States Sentencing Commission during 1988 and 1989. The Commission, which set the criminal penalties for individuals and firms who violated federal law, offered me an inside view into the criminal justice system. It gave me a better understanding of how prospective penalties affect criminal behavior. I began to see that debates among economists in academic journals could be quite removed from the real world. Sometimes, neither the authors nor the referees nor the journal editors really understood the institutions they were discussing.7

  Focusing so intensely on theory, economists too often take on the role of central planners. They identify the “right” prices that companies should charge and the “right” policies they should adopt without considering why market incentives haven’t encouraged firms to take these measures on their own. A greater problem, though, is that some economists try to pinpoint the subsidies or taxes that should be applied to goods to ensure that the “right” amounts are sold.

  But as Milton Friedman noted, a tax that might work in theory is difficult to make succeed in practice. Friedman and his wife Rose observed: “Government is one means through which we can try to compensate for ‘market failure,’ try to use our resources more effectively to produce the amount of clean air, water, and land that we are willing to pay for. Unfortunately, the very factors that produce the market failure also make it difficult for government to achieve a satisfactory solution . . . .Attempts to use government to correct market failure have often simply substituted government failure for market failure.”8

  We should remember the gasoline shortages of the 1970s that accompanied government price controls. People
may complain about paying a lot for gas today, when the market determines prices, but at least we know that we’re unlikely to find a gas station completely out of gas or, as we often saw during price controls, a lack of gas in all the gas stations in an entire area.

  Central planning has its appeal. After all, it’s hard for many people to comprehend how the seeming chaos of markets, with millions of separate decision makers, can somehow translate into economic efficiency. But economic freedom has its advantages. The key is to allow firms to set prices that accurately reflect all their costs and their customers’ preferences. Analysts and politicians can study trends for years without being able to account for all the factors that go into a single price. Planning accurate prices is near-impossible, and when the government gets them wrong, the results are shortages, black markets, or other harmful market distortions. Simply put, freedom better ensures that people get what they want. As Adam Smith noted, prices create incentives for people to meet the needs of others. Despite all the various guises in which central planning has been attempted, it is no real surprise that free economies work best.9

  1

  Are You Getting Ripped Off?

  Speculators, Price Gougers, and Other Good People

  “My constituents think someone rigged the price [of oil] and someone—them—is getting ripped off.”1 So thundered Republican Senator Pete Domenici at one of two Senate hearings convened to grill oil company executives about the steep rise in oil prices following Hurricane Katrina. Accused of price gouging and “unconscionable profiteering,” oil executives faced the “bipartisan wrath” of furious senators, which surely reflected the genuine anger felt by many of their constituents at rising gasoline prices.2 Some senators offered half-hearted objections that the oil companies might not really be the pillaging Mongol hordes as they were described. But no one on the panel seems to have made the really vital argument—what if, by dramatically raising prices during Hurricane Katrina, the oil companies were doing a good thing?

  Many people cite corporate greed or monopoly power as the only possible explanation why gas prices began rising even before Hurricane Katrina hit land and disrupted oil production in the Gulf of Mexico. After all, why should prices at the pump increase before a company’s costs have gone up? Some take this argument even further, claiming that prices should not have risen even after Katrina hit.

  Let’s consider the more difficult questions—why would prices rise before Katrina’s effects were actually felt? And how can this possibly be a good thing? Before analyzing the behavior of oil companies, let’s look at the motivations of individual consumers and speculators. If a powerful hurricane is forecast to hit land in a week, and people expect that gas prices are going to rise after the storm hits, then the difference in the price today and the expected post-hurricane price creates the opportunity for consumers to save money today by filling up their tanks when gas is cheaper. Speculators do the same thing. They profit by buying gas when it is cheap and selling it for a higher price after the hurricane. What’s more, by doing so, these speculators are performing a valuable economic service—they are removing gas from the market at a time when it’s plentiful and adding it at a time of shortage later.

  Oil company executives reason the same way. By raising gas prices before a hurricane, they reduce the demand for gas and are left with a bigger supply, which they can sell after the hurricane for a higher price. The downside of this action, of course, is that everyone has to pay more for gas before a hurricane hits. But no one talks about the upside—after the hurricane, when gas supplies are severely reduced due to the damage to production and supply lines, oil companies are sitting on increased inventories resulting from the pre-hurricane price hike. These inventories then hit the market right when they’re most needed. And this extra supply at such a crucial time helps minimize the overall price increase.3

  In other words, by raising prices before the hurricane hits, oil companies keep the post-hurricane price hike much lower than it would be otherwise. So, from an economic perspective, oil companies should raise prices before a hurricane until the price reaches the expected post-hurricane price. At that point, there will be no more profits to be made from this speculation, and there will also be additional inventories to help cover the expected post-hurricane shortages.4

  If the damage from the storm is worse than anticipated, prices will continue to rise. But in the long term, the higher prices will help accelerate the affected area’s energy recovery. After a hurricane, gas prices rise because the supply shrinks, and prices will begin falling once the supply improves. Rising prices in the short term actually help reduce prices in the long term by increasing supply. They do this in two ways. First, higher prices create a strong profit incentive for companies to find whatever ways they can to rush supplies into the area. The more profit to be made in a given area, the harder and faster people will work to transport gas there.

  Secondly, temporarily high prices reduce demand. They encourage people to car-pool, use public transport, and take other unusual steps. Indeed, this kind of economizing was seen throughout the country as gas prices rose nationwide after Katrina.5 Naturally, the poor will feel more pressure to take these kinds of steps than the better-off. This, at first glance, seems unjust. But the poor, like everyone else, will benefit when temporarily high prices result in increased gas supplies, ultimately leading to a faster reduction in prices.

  Temporarily higher prices assist energy recovery in other ways as well. The prospect of higher prices after a hurricane gives oil companies an incentive to set aside more gas as a reserve for such a contingency even before a specific hurricane is forecasted. Storing gas is costly, and if we want gas companies to bear those costs, we had better compensate them.

  Thus, we see that one need not resort to corporate conspiracy theories in order to explain Katrina’s effect on gas prices. The U.S. oil industry was no more monopolistic when gas prices rose just before Hurricane Katrina than it was two weeks earlier when prices were lower. Neither did the companies suddenly become greedier. They were simply reacting to the ever-present forces of supply and demand. Some may argue Katrina was merely a pretext for U.S. oil companies to raise prices, and that they jumped the gun by hiking prices before the storm actually hit. But if there were really no justification for the higher prices, then why did oil prices rise worldwide after the hurricane? The simple, non-conspiracy explanation is that we live in a world market for gas and the loss of Mexican Gulf production means less total oil for the world to spread around.

  But the senators who conducted hearings about gas prices seemed more interested in finding a politically-attractive scapegoat than evaluating the complex factors involved in determining gas prices. In fact, Senator Byron Dorgan freely admitted this, declaring, “None of us knows much about pricing . . . .But we see the pain of the consumers, and we see the gains of the companies.”6 So the senators considered various measures to put an end to “price gouging;” that is, to stop the temporary rise in prices during disasters that is so crucial to helping energy supplies recover.

  One such proposed measure was used to ill effect during the oil crunch of the 1970s—price controls. But instituting government price controls would have the precise opposite effect of the one intended. Without the prospect of high prices and high profits after a disaster, gas companies won’t store as much gasoline. Thus when disasters hit there would be much bigger shortages. The end result is easily predictable: artificially cheap gas available only to those people willing and able to wait all day in line to get it. Ironically, the cost of this waiting (in terms of the money people could have made if they had been working during that time) would probably more than wipe out the savings that consumers would reap from the controlled gas prices.

  The argument for “price gouging,” and against price controls, also applies to other goods and services. For example, stamping out price gouging by hotels would simply result in a larger number of people being left homeless after fleeing a storm.
No one wants people to pay more for a hotel, but we also want everyone to find some place to stay during emergencies, when hotels quickly reach capacity. As the price of a hotel room rises, some people will inevitably decide to share a room with others. A family that usually gets one room for the kids and another for the parents may choose to crowd together in one room rather than pay for another expensive room. At high enough prices, friends or neighboring guests may share quarters as well. The more people double up in this manner, the more rooms are freed up for other families and people who otherwise may be left with no place to stay.

  We economists may dispute many theories amongst ourselves, but we all agree on two things: first, that when demand rises or supply decreases, prices will rise; and second, that price controls result in shortages. This, of course, was the outcome of the gasoline price controls instituted in the 1970s. Americans waited in lines for hours to fill up their tank due to chronic shortages, which instantly disappeared as soon as the price controls were removed. So why does this debate over price controls never end?

  One problem is time lags. People see the short-term effects of controls in keeping prices low, but it is only later that the pernicious effects of shortages set in. People naturally find it easier to make connections between events that occur closely in time. Imagine if a day elapsed between the striking of a match and the resulting fire. Some people would fail to associate the two incidents. Many other events would have occurred during the intervening twenty-four hours that could seem to explain the fire.

  Suppose that tomorrow the government capped gasoline prices at their current price. Surprisingly, the controls would temporarily increase the amount of gas for sale. As previously mentioned, gas companies hold extra supplies because of the possibility that prices will rise in the future. The greater the chance of future higher prices, the more gas that companies will store. But when price controls are imposed, firms no longer have any expectation that prices will rise. In turn, they no longer have any reason to hold these inventories and thus begin selling them off.7