Paul Krugman Short Circuits
Give deregulation a chance.

By Jerry Taylor, director of natural-resource studies at the Cato Institute. For more on the electricity crisis in California, see Cato’s electricity website
February 21, 2001 10:00 a.m.

he latest salvo in the war over who's to blame for California's electricity crisis was launched last Sunday by

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Professor Paul Krugman in his column in the New York Times("The Unreal Thing"). Make no mistake: Even if electricity regulation bores you to tears, this debate is one of those key moments that will define the role of government throughout the next decade or more. If the meltdown gets attributed to "jungle capitalism," future attempts to disentangle the government from the marketplace are simply doomed. But if the meltdown gets attributed to bungling bureaucrats and botched regulation, the on-again, off-again march toward free markets might just accelerate and gain new momentum. For the Left and the Right, everything now hinges on the public interpretation of events in the Golden State, and anyone with a stake in that fight — whether they know anything about electricity economics or not — is weighing in on the subject as if their life depended on the outcome.

Krugman's role in this fight is crucial. He's got the most important paper in America at his disposal and he's an economic heavyweight. But given his stature in academia, he can't go about just screaming populist primitivism at the top of his lungs like, say, Governor Gray Davis. He's got a reputation to worry about among people who know something about economics (a reputation, by the way, which has been generally well earned). So, through Krugman, we can pick up something about what the outer-most argument against the market might be without falling off into pitchfork know-nothingism.

His critique is actually somewhat surprising. Strip away the political rhetoric, and Krugman concedes the argument that California's "deregulation" was a mixed bag from the start. Wholesale generation markets were largely deregulated but retail prices were not. Krugman acknowledges (as if he has any real choice in the matter) that price controls on a scarce good will always and forever lead to disaster. Krugman rightfully hints that those price controls were the main cause of the meltdown.

But here comes the slick two-step; the demand for electricity is so inelastic in the short run that retail prices, according to Krugman, would have had to go through the roof to reduce consumption enough to head off the California disaster. (If you think you're hearing echoes of the argument against decontrolling oil and gas prices in the late 1970s, you're right). Rate hikes of that magnitude, he says, would be politically unacceptable. So complete deregulation was not and is not an option, and free-market types should quit pretending that they were strong-armed by quasi-socialist politicians back in 1996 when they passed "deregulation" in the form of A.B. 1890.

And so we have an economic assertion (demand is not responsive to anything short of monstrous retail price spikes) and a political assertion (voters would hang politicians who allowed such a thing to happen). Fortunately, we can test both.

In August, 2000, rate-payers served by San Diego Gas & Electric were left unprotected by A.B. 1890's retail-price controls because their utility had managed to collect its share of stranded costs (long story; don't ask) before the crisis hit. Retail prices indeed skyrocketed, albeit not as high as wholesale prices would demand to balance supply. Electricity consumption, however, immediately dropped by a whopping 9 percent.

That was particularly impressive given the near certainty that San Diego's electricity rates would be quickly capped by politicians, as they were but a month later in September. Rate-payers for the most part didn't invest in long-term energy efficiency because they believed (correctly) that the rate hikes would prove temporary. Had they been convinced that those high prices would stay high for some time, even greater demand reductions would have been seen.

So even in the face of moderate rate hikes, Californians

“Thanks to insinuations by economists who ought to know better, polls show that most Californians think that the price spike is entirely attributable to the rapacious avarice of Western power generators.”

appear quite capable of significantly reducing demand. News reports continue to demonstrate that California's business community has instituted major operational changes to reduce peak demand, further belying the argument that moderate price hikes cannot significantly affect consumption.

Are rate hikes in California politically impossible? Perhaps, but that has less to do with voters being genetically hard-wired to demand Naderite regulation than it does with widespread suspicion that the price hikes are the result of profiteering and not scarcity. Thanks to insinuations by economists who ought to know better, polls show that most Californians think that the price spike is entirely attributable to the rapacious avarice of Western power generators.

But when consumers aren't fed such baloney, their tolerance for temporary price run-ups is surprisingly large. On the east coast, for instance, skyrocketing natural gas prices have socked consumers far more heavily than skyrocketing electricity prices have socked Californians, yet there is surprisingly little agitation for more rigorous rate caps.

Moreover, Krugman's attempt to define retail price decontrol out of political existence stumbles to the extent that targeted decontrol is ignored. For instance, if California simply freed prices for the largest 30 or so power consumers in the state, a huge chunk of demand would be freed up without subjecting Granny to the horrors of the free market. Electricity economists such UC Berkeley's Severin Borenstein argues that this alone would halt the meltdown.

Krugman also takes a shot at the Right's charge that the prohibition against long-term contracts between utilities and power generators exacerbated the crisis. No argument here: If the electricity price spike is a consequence of higher input costs (rising natural gas prices) and a drastic decline in hydro-electric power due to falling water tables, then long-term contracts would have made no difference. All they would have done is changed who would have gone bankrupt (in that case, the generators instead of the utilities). If the price spike is a consequence of market power, on the other hand, long-term contracts might well have prevented the run-up. Krugman is absolutely correct to argue that the Right can't have it both ways.

"There's a myth in the making," concludes Krugman, "one that portrays California as a victim, not of deregulation gone bad, but of quasi-socialist politicians who didn't give deregulation a chance to work." But Krugman himself acknowledges that it's a bit more than a myth. And even if he understates the role that price decontrol could play in alleviating the crisis, Krugman the economist is more impressive than Krugman the politician. The electorate in California, after all, is not necessarily the electorate of East Germany.

Yet Krugman's right about one thing: No amount of laissez faire medicine would have prevented the initial price spike. Conservatives simply aren't doing the math if they doubt the role played by wholesale natural gas costs in fueling wholesale electricity prices in California, and they're kidding themselves if they blame the bulk of the higher input costs on state regulators.

Free markets don't guarantee lower prices in any and all occasions: They simply ensure that scarce goods are distributed efficiently and that the proper incentives exist to remedy supply and/or demand shocks as quickly and painlessly as possible. An economist without an ax to grind would argue that political management of price shocks through heavy-handed legal orders is less satisfactory to consumers and to the economy at large than the private management of price shocks through prices. Such an economist might also point out that price controls don't regulate away costs: In California, they simply bury them in the state budget and eliminate any useful role they might play in reducing demand.

But Paul Krugman, like most participants in this debate, has an ax, and in the midst of a debate that will determine the extent to which regulators can meddle with markets in the future, he wields it with relish.