MAXIMIZING HAPPINESS IN FUTURE POSITIVE OIL PRICE SHOCKS

by

James D. Coan

April 7, 2009

A Senior Thesis presented to the Faculty of the Woodrow Wilson School of Public and International Affairs in partial fulfillment of the requirements for the degree of Bachelor of Arts.

Acknowledgements I would first like to thank my thesis adviser Amy Craft for spending hours answering my many questions. Before taking her energy economics class last year, I would think of policies to reduce oil consumption without really analyzing the damage the oil use caused. This paper is a direct result of my desire to know more about the costs of an oil shock. The notion that this work is my senior thesis gives the impression that it is an endeavor lasting one year. Yet oil and energy have been interests of mine since 10th grade, and I thank all of those who provided opportunities for me to learn about the field through internship opportunities. Jon Hurwitch at Sentech, Inc. in Bethesda, Maryland gave me my first internship before my junior year of high school, and I then learned from Therese Langer at the Transportation Program of the American Council for an Energy-Efficient Economy, and Frank Verrastro, Dave Pumphrey, and Jen Bovair among others at the Center for Strategic and International Studies. Much of my learning came from entering policy contests about energy, and I thank those at Chrysler (then DaimlerChrysler), the Brookings Institution, the Roosevelt Institution, and the Presidential Forum on Renewable Energy for deciding to put up a little money to encourage students to think about automotive technology or policy. This paper covers two huge bodies of literature, and I must thank the leading scholars in these fields for making my work possible (as well as those who created the database Scopus for making the process of finding their work easy). Of all those working on the effects of oil on the economy, the work of economists James Hamilton and Lutz Kilian proved the most influential for me. Additionally, I am grateful for the work of Daniel Kahneman, Rafael Di Tella, Robert MacCullough, Andrew Oswald, Alois Stuzer, Bruno Frey, and many others for their work with happiness and subjective well-being. I knew nothing about surveys of well-being before starting, and I find the possibilities of analyzing a whole suite of policies using happiness as a metric extremely exciting. I plan to use the work in this paper for years to come. Deviating some from effusive praise, I admit that my interest in oil policy blossomed to a large extent because I felt an opening for creativity while so few policy ideas to reduce oil use were able to be seriously discussed on Capitol Hill before 2007. However, I am fine giving excessive praise to my parents who have supported me through all my pursuits including energy. There are relatively little things they have done like bankrolling the many printer cartridges I went through while I was home. But the core point of this paper is that happiness and not just money is what matters. I thank them for much more for always checking in to make sure I was getting enough sleep while fighting mononucleosis and lyme disease during this process and making sure I was staying generally happy while writing about happiness.

Table of Contents Abstract_________________________________________________________ 4 Executive Summary________________________________________________ 5 Chapter 1: Another Oil Shock Is Very Possible__________________________10 Chapter 2: The Traditionally Measured Impacts of an Oil Shock____________ 19 Chapter 3: Measuring Happiness_____________________________________ 47 Chapter 4: How an Oil Shock Impacts Happiness________________________ 86 Chapter 5: Maximizing Happiness in the Next Positive Oil Price Shock______ 99 Works Cited____________________________________________________ 112 Appendix A: Data on Impacts of an Oil Shock_________________________ 119 Appendix B: Subjective Well-being Data______________________________122

Abstract

Oil prices skyrocketed in the first part of 2008. While the world is currently mired in an economic downturn that has substantially reduced demand, another rapid increase in the price of oil known as an oil shock has a reasonably high risk of occurring again. Factors contributing to previous shocks including political instability in the Middle East, the power of the Organization of Petroleum Exporting Countries (OPEC), and growth in developing countries are all expected to be present in the future. These oil shocks impact a whole host of factors that affect well-being. Some like income and various macroeconomic variables are negatively affected, but there are also benefits from reduced vehicle miles traveled. While the effects can be qualitatively described as bad or good, it is difficult to know how individuals are impacted and which impacts are the most significant. This paper tries to quantify the impact by combining literature on oil shocks with another body of literature that analyzes surveys of happiness or life satisfaction of individuals. These subjective well-being surveys have been given since the 1970s, and economists have analyzed them to find connections between individual well-being and the variables an oil shock impacts. The negative impacts are at least an order of magnitude worse than the offsetting positive ones. For a one-year-long $20/barrel shock, the worst impact appears to be related to a fear effect of unemployment among the general population. Manufacturers inflexibility in response to changing consumer preferences appears to be a major cause of unemployment, although changes to the trade deficit can also play a significant role at times. Types of policies that can reduce the negative impacts of an oil shock should primarily attempt to reduce consumption of gasoline and diesel, but there also may be some benefit from encouraging manufacturing flexibility, giving cash transfers to lower-income individuals during a shock, increasing domestic supplies, and taxing gasoline to reduce volatility in consumer automobile purchases.

Executive Summary Despite the current economic crisis, oil prices will likely once again quickly increase much as they did in 1973, 1979, 1990, and between 2002-2008. The political uncertainty in the Middle East and the power of OPEC that led to the oil shocks before this decade are still present, and the most recent major oil price increase that culminated with prices reaching over $147/barrel in the summer of 2008 demonstrates that rapidly increasing demand and potentially speculation can also cause oil prices to rise. With all these risk factors for another shock, it is reasonable to try to reduce the risks of a future shock through government policy. In order to make appropriate policy from the perspective of the U.S. government, the impacts of an oil shock on the well-being of U.S. residents must be known. Chapter 2 analyzes the effect of a unit standard deviation oil price shock, which translates into a sudden increase in the price of oil of about $20/barrel, or the equivalent to about 50 cents/gallon of gasoline. A shock negatively impacts income and various macroeconomic variables (unemployment, GDP, inflation, and interest rates) while tending to increase the trade deficit, which can pose risks. However, by reducing vehicle miles traveled (VMT) and oil use, a shock also has some positive impacts of reduced air pollution, traffic and traffic deaths. Economic analyses of oil shocks show that the impact of an oil shock on macroeconomic variables may only have 20-25% of the effect as it once had in the 1970s. Elasticity of VMT with respect to the price of gasoline has also

declined substantially. However, impacts on individual incomes have not declined nearly as precipitously, and the effects on the trade deficit and dollar may be more significant. This body of literature gives only a sense of how these changes actually impact the well-being of individuals. For instance, rising unemployment is clearly bad, but it is difficult to know how the negative impact compares with other impacts of a shock. Without this knowledge, it becomes close to impossible to have a good sense of whether any particular government policy designed to reduce the impacts of a future shock will actually improve well-being on the whole. To fill this gap, Chapter 3 surveys another body of literature that has analyzed surveys of happiness or life satisfaction. These subjective well-being (SWB) surveys have been administered to hundreds of thousands of people in the U.S. and Europe since the early 1970s. Various economists have used these surveys to calculate how income changes, macroeconomic variables, and commuting time affect SWB. For instance, these surveys show that a given shortterm income loss is about five times worse than the same long-term gain, and becoming unemployed is as bad as falling from the top of the income distribution to the bottom. The surveys also provide a way to think about how to account for premature death from traffic fatalities and air pollution. These surveys are considered quite reliable. Responses to these SWB surveys are well-correlated with a host of outward signs of well-being such as assessments of happiness by friends and family and the frequency of authentic

smiles (Blanchflower and Oswald 2004). Temporary mood changes rarely affect answers, and answers to questions about life satisfaction and happiness are quite similar (Eid and Diener 2004; Di Tella et. al. 2001). When using SWB surveys, all the impacts of an oil shock can be combined into one common metric of well-being. Such an outcome corresponds well to the goals of Thomas Jefferson in the Declaration of Independence, the Utilitarian philosophers Jeremy Bentham and John Stuart Mill, and utilitymaximizing modern-day economists, who all believe it is desirable to maximize well-being (or utility) of individuals. Chapter 4 combines the work of Chapters 2 and 3 in order to determine the actual impact of a unit oil price shock on SWB. The effect is overwhelmingly negative, as negatives outweigh positives by at least an order of magnitude, even when accounting for the sensitivity analyses. The most prominent negative impact is due to a population-wide response to a higher unemployment rate, likely from feelings of greater job insecurity. Traditional economic techniques that only focus on the decisions of individuals rather than surveying their feelings could not have led to such a conclusion. Chapter 5 concludes the paper by discussing possible policies that could potentially maximize SWB given a future oil shock. These policies address the mechanisms that lead to the negative effects of oil price shocks. Consumers feel an income loss primarily because of changes in gasoline prices. One major reason that macroeconomic variables are affected appears to come from a change in consumer purchasing behavior away from certain durable goods, toward more

efficient products, and between different industries. This change in behavior can expose frictions in various industries that cannot quickly respond to preference changes, resulting in unemployment and GDP loss. Impacts to the trade deficit and the dollar can also substantially influence the movement of macroeconomic variables, especially interest rates. Changes to the trade deficit and the dollar may actually lead to benefits for the U.S. in the short-term in some instances, but an oil shock increases risks of substantially negative impacts. Reduced consumption of fuel should reduce impacts on individual budgets and minimize changes in consumer behavior. A fuel economy standard, rebates and taxes on new vehicles based on efficiency, a program to purchase inefficient used vehicles, and a gasoline tax can all reduce consumption. In some circumstances, it may be helpful to make direct cash transfers to lower-income households during an oil shock. The government can also look into mandating more flexible automobile manufacturing and increasing domestic supply. Future studies can analyze the cost of implementing these various policies using the SWB calculations in Chapter 3. Despite the advances in this paper that allow policymakers to think about well-being together rather than many disparate individual metric, good judgment is still essential. Policies should be targeted on the basis of a judgment of the magnitude, duration, timing, frequency, and to some extent source of future shocks. The uncertainty for many of the impacts to macroeconomic variables is quite large. Finally, this paper discusses many ethical issues including discounting future happiness and accounting for premature death and the well-

being of children, future generations, foreigners, and non-human animals. The use of SWB surveys can be a great advance in the analysis of policy, particularly to address oil shocks, but they alone will not provide all the answers.

Chapter 1: Another Oil Shock Is Very Possible Four years from now, we may expect the price of oil still to be at $115 a barrel, though we would in fact not be all that surprised if it is as low as $34 or as high as $391! - James D. Hamilton, energy economist (June 2008) In the next couple of decades, a reasonably high risk exists that oil prices will once again rapidly increase. This hypothesis inspires this paper. Historical evidence supports this prediction of one or more relatively sudden and noticeable increases in oil prices, a phenomenon known as a positive oil price shock.1 At least six different oil shocks have affected the U.S. since WWII, five of which have occurred since 1973. Political events in the Middle East that resulted in rapid reductions of supply primarily caused the shocks before 1998. Tensions that could lead to future supply reductions are still present in the region. Yet this most recent price increase in the last decade appears to show that increased demand and possibly speculation in oil can also result in price increases (Hamilton 2008b).

Historical Oil Shocks and Price Movements 1945-1998 Five major political events have triggered sudden reductions in oil output for the world market between WWII and Operation Desert Storm, as shown in Table 1.1.

Some writers (i.e. Hamilton 2003) have tried to formalize the notion of an oil shock, but the general idea of a relatively rapid and noticeable price change is sufficient for the purposes here.

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Table 1.1: Political Events that Led to Supply Reductions Date Event Drop in World Production (%) Nov. 1956 Suez Crisis 10.1 Nov. 1973 Arab-Israeli War and OPEC Response 7.8 Nov. 1978 Iranian Revolution 8.9 Oct. 1980 Iran-Iraq War 7.2 Aug. 1990 Persian Gulf War 8.8 Source: Sill 2007 All the political events that caused these reductions clearly occurred in the Middle East. It should be noted that the 1973 reduction was a result of an oil embargo in which Arab nations within the Organization of Petroleum Exporting Countries (OPEC)2 refused to sell oil to the U.S. and a few other nations who supported Israel during the Arab-Israeli War, which is also known as the Yom Kippur War. The embargo lasted from October 1973 until March 1974. There had been a much less successful oil embargo in 1967 after the Six-Day War (State 2009). However, as shown in Figure 1.1, these supply reductions led to oil shocks of very different magnitudes and durations.

Currently twelve countries comprise OPEC: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Angola joined in 2007. Ecuador was a member from 1973-1992 and then rejoined in 2007. Indonesia was a member from 1962-2008.

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Figure 1.1: Real Oil Price Since 1945

Source: Hamilton 2008b using monthly average West Texas Intermediate prices3 This graph shows the impact of these various supply shocks, which had widely different effects in terms of magnitude and duration: 1956: Despite a very large reduction in production, world prices stayed relatively constant. At the time, the U.S. was still a dominant and growing supplier of oil and had enough spare capacity through the Texas Railroad Commission to mitigate the impact of the supply shock on price (Yergin 1991). 1973: Prices almost immediately increased by about $30/barrel, more than doubling the price of oil. The prices stayed relatively constant for more than the next five years, not significantly changing until the next oil price shock. 1979: Although the Iranian Revolution and the Iran-Iraq War were two separate political events in 1978 and 1980, oil prices only spiked once beginning in the spring of 1979. The magnitude of the increase at its maximum was about $50/barrel. Unlike the previous oil shock, prices began to retreat soon after
3

They are deflated with the September 2008 consumer price index (CPI).

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reaching their peak, although they still remained above the levels of the 19731979 period in real terms until 1985. 1990: The price of oil very briefly increased about $30/barrel and then came back down to its original level in a matter of a few months. In addition to the positive shocks, the graph also indicates a negative supply shock in 1986 when Saudi Arabia steeply increased its production, leading to an oil glut and precipitous drop in prices (Yergin 1991). Additionally, although prices were generally low before 1973 and from 1986-1998, the volatility in the second half of the period is much greater (Regnier 2007). The oil prices had been generally set at a nominal level, so they fell gradually in real terms before 1973, but afterward factors such as higher summer demand and varying worldwide economic conditions affected prices (Sill 2007). Even with this volatility, the prices generally stayed between $20-$40/barrel in real terms.

Varied Reasons for Oil Price Increases Since 1998 The price of oil rose dramatically from 1998 to mid-2008. The increase can be split into three main shocks, each of increasing magnitude from spring 1999 fall 2000, summer 2002 summer 2006, and winter 2007 summer 2008. The increases were about $20/barrel, $50/barrel, and $80/barrel respectively. After each rise, prices quickly fell by roughly $20/barrel for a short period of time. The increases occurred for a variety of reasons, some of which are similar to drivers of the price before 1998. Supply restrictions were a likely cause of a brief shock of about $10/barrel from January-March 2003. A roughly two-month-

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long Venezuelan oil strike began in December 2002, and the markets likely responded to the increasing likelihood of the invasion of Iraq, which occurred in March 2003 (BBC 2003). In 2002, Venezuelan oil production had been 2.9 million barrels/day (mb/d), and Iraqs was 2.1 mb/d, compared with total world production of 75 mb/d, meaning that a disruption of supply from either country was significant (BP 2008). As was the case in the 1980s and 1990s, business cycles and seasonal patterns also drove the price of oil. For instance, oil prices had fallen in 1998 during the Asian financial crisis, and they fell again in 2001, probably in response to the U.S. recession at the time. Prices then began increasing again in 2002 as the U.S. economy recovered. However, demand also appears to have driven the price of oil after 2002. Hamilton (2008b) among others supports the theory that strong global demand for oil, especially from rapidly developing nations such as China, has contributed to an increase in the oil price in the past decade. Developing a new oil field requires a long lead time, allowing growth in demand to outpace new supplies for years. Concerns about the availability of supply likely exacerbated the impact of demand growth on price. National Oil Companies control much of the worlds supply, and some countries have restricted international access to these sites (Jaffe and Soligo 2007). Economists doubt the presence of an actual approaching physical peak of oil production, arguing that production is responsive to price and that many substitutes for oil (i.e. unconventional fuels, biofuels, and electrified vehicles) can be brought into the market within an intermediate timescale

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(Watkins 2006). However, restrictions on the physical access to sources of oil and these time lags needed to bring these alternatives to market create opportunities for prices to increase markedly before markets and governments can sufficiently respond. Additionally, as Congress heatedly debated during the summer of 2008, speculators may also have contributed to some of the price increase, at least in the last shock beginning in early 2007. Spector (2008) believes this argument, noting that many new players got involved in the oil market who were heavily weighted toward assuming the price would continue to increase. Hamilton (2008b) provides theoretical support, saying that if buyers had different amounts of information, they could push up prices. In this case, risk-averse people would not balance these ill-informed speculators who are betting on increased prices. Of course, this herd mentality in terms of speculators could also run in reverse, quickly driving prices down.

Gasoline Price Shocks Gasoline prices rather than oil prices are responsible for much of the impact on individual incomes, the broader economy, and reduced driving. In general, the price of gasoline tracks the oil price. A barrel of crude oil is equivalent to 42 gallons, so a $1/barrel increase in the price of oil should translate into an increase of 2.38 cents/gallon assuming all other components of the price of gasoline such as the refinery margin and taxes remain constant.

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However, refinery margins that make up much of the difference between the oil price and gasoline price can fluctuate. In rare cases like in 2005 in the aftermath of Hurricanes Katrina and Rita, gasoline and oil prices can move in opposite directions. Some damaged refineries in the U.S. along the Gulf Coast shut down, creating a shortage of gasoline supply that led to a very significant price shock for gasoline in the U.S. This gasoline shock occurred even as the world price of oil declined slightly (Edelstein and Kilian 2007). A future natural disaster could cause another gasoline price shock in the absence of an oil price shock if this spare refining capacity issue is not fixed.

Significant Potential for Future Shocks The supply and demand causes of previous oil shocks are quite likely to be present in the future. The possibility of a future oil price shock is a real risk, and public policy can try to minimize the potential for losses should prices rise quickly again. Political instability is still present in many of the largest exporters, and OPEC is willing to cut supply in order to raise prices as has been shown already in 2009 (Reuters 2009). A brief look at major oil exporters points to any number of problems that could lead to a supply shortage. For instance, Venezuelan and Russian leaders have asserted themselves through resource nationalism, and fighting in Nigeria has caused reductions in production (Jaffe and Soligo 2007). Terrorism poses a threat to major oil exporters, such as in February 2006 when two cars carrying explosives tried to ram the gates of the Abqaiq oil production

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facility in Saudi Arabia that could have taken 4-5 mb/d off of the market for one year had it succeeded (BBC News 2006). These supply constraints could have even greater impact on prices today than in the 1970s. The short-term elasticity of demand for gasoline has dropped very steeply from between -0.21 and -0.34 in the 1975-80 period to only between -0.034 and -0.077 between 2001-06 (Hughes et. al. 2008). Gasoline is currently about 45% of overall oil use, but it appears as though the price elasticity of overall oil use is very similar to the elasticity for gasoline; Hamilton (2008b) calculates an elasticity for oil of -0.26 for the years 1978-81 (EIA 2009b). Inelastic demand can lead to greater price increases by amplifying the effect of a supply shock. The five-fold or so reduction in elasticity more than outweighs the relatively minor reduction in production from OPEC and the Middle East since the 1970s, as shown in Table 1.2. Considering that OPEC and the Middle East have 61% and 75% of world proved reserves of crude oil respectively, the long-run trend should be toward greater concentration of production (BP 2008).4

Year

1973 1979 1990 2003 2007

Table 1.2: Proportion of Oil from OPEC and Middle East Down Slightly World OPEC Middle East U.S. Production Production Production Production (% of World) (mb/d) (% of World) (% of World) 58.5 53.1% 36.3% 17.9% 66.1 47.5% 33.3% 15.3% 65.5 38.3% 26.8% 13.6% 77.0 41.1% 30.3% 9.6% 81.5 43.2% 30.8% 8.4% Source: BP 2008

This statement does not assume alternative fuels, which can reduce the concentration.

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Predicting when the next supply shock is inexact, but it is clear that no 20year period has gone by since WWII without a significant reduction in supply. Since 1945, a major supply reduction has occurred about every ten years.5 Compared with supply issues, the possibility of demand growth again causing oil prices to rise may seem improbable given the current state of the world economy, but given an outlook of a couple of decades, it is very possible that oil demand will recover. Developing countries still have much room to increase their oil consumption. For example, residents of China currently only use about 10% of U.S. consumption per capita (Hamilton 2008b). Unlike the potential supply and demand constraints, the influence of speculators may somewhat diminish if governments curtail their ability to get involved in the oil market. More broadly looking at investment, however, would indicate that currently low prices for oil may lead to future price shocks if it discourages investment searching for new supplies in the present.6 While a price shock might not happen in the next couple of decades or longer, history indicates that another shock has a high likelihood of occurring. Public policy should address this risk, but appropriate policies can only be designed with an understanding of the magnitude and composition of the effects of an oil price shock.

There is an average of 9.7 years (+/- 1.8 years) between the major supply reductions in 1956, 1973, 1978, 1980, 1990, and 2003. 6 It could also blunt the political drive to implement policies that would reduce consumption.

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Chapter 2: The Traditionally Measured Impacts of an Oil Shock Nowadays people know the price of everything and the value of nothing - Oscar Wilde, The Picture of Dorian Gray (1891) An oil shock affects many variables that can increase or decrease wellbeing. For this paper, the effects are divided into four broad categories: 1) income loss; 2) changing macroeconomic variables (unemployment, gross domestic product (GDP), and inflation/interest rates); 3) trade deficit; and 4) benefits of driving less (reduced traffic deaths and property damage, traffic congestion, and air pollution). The first three categories have negative impacts, while the fourth is positive. This chapter contains many numbers that estimate these impacts, but they should be approached with caution. The impacts on macroeconomic variables and trade deficit are quite uncertain. Additionally, as author Oscar Wilde reminds us with the quote above, these numerical impacts themselves are just numbers. They do not correspond to well-being until they are combined with the effects on happiness described in Chapter 3. In contrast, the descriptions of the mechanisms that lead to the changes in macroeconomic variables and the trade deficit can directly influence the types of policies considered. For instance, it appears as though much of the reason for the decline in GDP and rise in unemployment is due to changing consumer behavior and the subsequent inability of manufacturers to respond to the changes quickly. Therefore, polices that reduce consumers percentage changes in income and those that try to increase flexibility of manufacturing may have merit. Yet if the

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major cause of a GDP loss were due to a supply shock that manufacturers felt, governments should probably focus more on giving tax breaks to businesses.

A Unit Positive Oil Shock The effects in this chapter are described for a one standard deviation unit oil shock, or unit shock for short. In other words, a unit shock occurs when the price of a barrel of oil increases by one standard deviation, which is determined by looking at historical oil prices. This measurement is used in many of the analyses that try to measure the impact of an oil shock on macroeconomic variables, so it is adopted for this paper. A unit shock is $20/barrel in current dollars, which is slightly under $.50/gallon of refined product. This figure was calculated using costs of imported crude oil since 1973 (EIA 2009a; EIA 2009b). Various measurements starting with 1973 using monthly, quarterly, and yearly data and ending in 1988, 1993, and 2008 all yielded standard deviations between $18 and $20.50/barrel. Various end dates were tested because some of the analyses end earlier than other, potentially altering the definition of a unit shock. The standard deviation for gasoline prices has a slightly wider range with values of $.47/gallon to $.54/gallon depending on the end date for the data (EIA 2009b). For this analysis, it will be assumed that the effect on gasoline prices of a unit shock is $.50/gallon. The slightly higher figure of $.54/gallon measures data until 2008, which also includes the gasoline-specific shocks near the time of Hurricanes Katrina and Rita described in Chapter 1.

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EFFECTS ON INCOME An oil shock will be thought of as a tax on consumers. Consumers have an expected budget that includes some fuel usage, and a higher price for fuel reduces disposable income to pay for that fuel as well as all other goods. Changes to the price of gasoline and motor oil account for over 90% of the costs, with fuel oil and other fuels as the remainder (BLS 2008). The impact strongly depends upon the income quintile of the consumer, as shown in the table below, with reductions ranging from about 0.5-2% of income from a unit shock.7 Thus, if gasoline prices are $2/gallon, gasoline accounts for about 2-8% of income, making it a very significant component of a family budget.

Table 2.1: Effects of an Oil Price Shock on Income by Quintile Expense of Income Income After Gallons $.50/gallon % of AfterQuintile Taxes Used increase tax income 1 (lowest) $10,534 402 $201 1.91 2 $27,419 674 $337 1.23 3 $45,179 907 $453 1.00 4 $70,050 1,128 $564 0.81 5 $150,927 1,404 $702 0.47 Sources: BLS 2008; EIA 2009b The impact of the oil price increase may be less for some consumers who can reduce their fuel consumption. These consumers reveal their preferences that the marginal use of the fuel is worth less than the elevated price for it. However, this effect is small in the short-run because there are low short-run elasticities of 3-7%, and higher-income consumers for whom the higher price is less significant are the ones who are more elastic (Hughes et. al. 2008). They recognize that it
7

This calculation assumes that all fuel is the price of gasoline. It appears as though residual fuel oil is about one-half of the

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may seem surprising that higher-income individuals have more elastic demand, but they often have multiple vehicles that consume different amounts of fuel, and they also take more unnecessary trips that can be cut back. This calculation may underestimate the impact on some consumers who need to borrow extra money to pay for their gasoline use. Much of this borrowing will occur on credit cards, which had an average interest rate of 13.5% as of July 2008 (Woolsey and Schulz 2009).

IMPACTS ON MACROECONOMIC VARIABLES How an Oil Price Shock Impacts Macroeconomic Variables Scholars disagree on the mechanisms by which an oil price shock changes macroeconomic variables. Nevertheless, their work points to four major potential causes: 1) a supply shock that impacts businesses; 2) altered consumption patterns among consumers and firms; 3) trade deficit impacts; 4) a Federal Reserve response. Altered consumption patterns negatively impact the economy when businesses are not flexible enough to respond to changes in preferences, thus leading to GDP loss and unemployment. The first notion that an oil shock impacts business by raising production costs is a conventional explanation for how the shock is transmitted through the economy (Guo and Kliesen 2005). This impact could then lower firms profits and reduce their willingness to invest in capital goods (Cologni and Manera 2008). It is also plausible that these firms would lay off employees in order to become

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more profitable. Those who were laid off and those who feared getting laid off would then reduce their purchases of goods, further worsening the economy. A more recent explanation is that an oil shock harms the economy by changing the consumption patterns among consumers and to some extent firms. Edelstein and Kilian (2007) take an in-depth look at how consumer purchasing behavior changes with an oil price shock. They attribute changes in behavior to an unexpected loss of discretionary income and an uncertainty effect that reduces willingness to purchase goods, especially certain durables like automobiles. In their opinion, other possible mechanisms from the consumers include an increased desire to save, known as precautionary saving, and a desire to avoid spending on goods that use more energy. The effect from consumers can be both a result of decreased income and greater uncertainty about future energy costs, and the uncertainty can especially hurt vehicle sales (Kilian 2008). This change in consumer behavior can hurt businesses and lower the firms willingness to invest. It can also lead to difficult labor and capital reallocations (Gronwald 2008). Various sectors can be affected to different degrees, and these imbalances as well as the inability to coordinate among firms can harm the economy (Lardic and Mignon 2008). The third mechanism involves the impact of oil imports on the trade deficit and U.S. dollar. However, the impact may be positive or negative, especially depending upon the willingness of foreign lenders to fund the deficit and the confidence of foreigners in the dollar and U.S. economy more broadly (Higgins et. al. 2006). A greater trade deficit can potentially make it more

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difficult to find capital to fund the deficit, raising interest rates. Higher interest rates can deter investment and therefore impact GDP and other macroeconomic variables. Yet a weaker U.S. dollar will tend to boost exports, also impacting these variables but potentially in a positive way. Finally, some have argued that a large percentage of the impacts on the economy are due to the monetary policy response to the oil shock rather than the shock itself. Bernanke et. al. (1997) provides a clear example of this reasoning. They say that most or even all of the reduction in GDP from the shocks of 1973, 1979, and 1990 are due to a monetary response.

Plausibility of Transmission Mechanisms from Shock to Macroeconomy Although no clear consensus exists, it appears as though the literature generally supports the consumer-based demand-side account. The transmission channel through trade also seems very plausible. In contrast, the supply-side and monetary policy impacts appear to have more limited impacts, although they are still present for some industries and in some circumstances. Consumer spending accounts for more than 70% of GDP, making relatively small percentage changes in consumption behavior quite significant from the perspective of manufacturers (Goodman 2008). Two economists who have extensively studied the impact of oil on the broader economy, James D. Hamilton and Lutz Kilian, both believe consumers are the dominant force in affecting macroeconomic variables, particularly GDP. Noting that rising oil prices until 2005 had still not led to a decline in consumer consumption or a

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recession, Hamilton writes how the experience is consistent with the belief that the key mechanism whereby oil shocks affect the economy is through a disruption in spending by consumers and firms (Hamilton 2008a). Edelstein and Kilian (2007) make an even stronger argument for the preeminence of this effect, arguing that in the absence of a consumer and firm response, the effects of energy price shocks on the economy will be small.8 Few if any economists have tried to directly contradict this argument, although some have emphasized different mechanisms such as the monetary policy response. While fewer have directly tried to emphasize the importance of changes to the trade deficit and U.S. dollar, the magnitudes involved suggest that they could both significantly impact macroeconomic variables. In 2007, U.S. net imports were about 12 mb/d, so a year with a price that is $20/barrel higher would amount to a trade deficit that is larger by about $85 billion assuming everything else stays constant (How Dependent 2008). Such a value is about 0.6% of GDP, which is relatively significant. It may seem somewhat small considering the trade deficits in this past decade were sometimes more than 6% of GDP. However, many commentators were concerned at such deficits that were very large from an historical perspective (Iley and Lewis 2007). And as Figure 2.1 shows, with higher prices, a large percentage of the deficit can at least be calculated from oil prices. Finally, Rebucci and Spatafora (2006) calculate that there can be significant impacts to macroeconomic variables from changes to the trade deficit.

This may seem surprising considering oil is a major manufacturing input.

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Figure 2.1: Oil As Large Percentage of Trade Deficit

Source: The Economist (FEER 2008) In comparison, there are fewer arguments in favor of attributing negative outcomes of an oil shock as primarily being a result of a supply shock to businesses or monetary policy. Lee and Ni (2002) find that it is only a supply shock to firms that are very oil-intensive, whereas others are primarily impacted because of changes in consumer preferences. Automobile manufacturers, for instance, are primarily negatively impacted from changes in the purchasing decisions of consumers, not from higher prices that make manufacturing more expensive. As for monetary policy, quite a few papers have argued that monetary policy can be significant, but it does not account for the majority of the negative impact on output (Hamilton 2008a). One criticism of the Bernanke et. al. (1997) paper is that it omitted impacts in quarters three and four after the shock, which is when oil shocks actually have their largest effect on GDP (Hamilton and Herrera 2004).

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How an Oil Shock Impacts the Magnitude and Importance of the Trade Deficit In theory, a larger trade deficit can have a short-term impact of raising interest rates in order to attract new investors who are willing to lend to the U.S. Longer term, there is a concern about the sustainability of the trade deficit. However, oil exporters have shown great willingness to lend to the U.S., which could minimize or even reverse the interest rate effect. Additionally, the value of foreigners investments in the U.S. will likely fall, and these valuation effects can lead to the seemingly ironic result that the U.S. has an improved international investment position (IIP) even with a larger trade deficit (Helbling et. al. 2005). This IIP is the basis for the notion of sustainability of the trade deficit. Nevertheless, although a larger trade deficit may have benign or even somewhat positive consequences, it can be risky, and it is unclear whether future lenders will be as willing to lend to the U.S First of all, an oil shock probably does not lead to an increase in the trade deficit as large as 0.6% of GDP because U.S. exports to oil exporting nations also increase. At least to the Middle East, Higgins et. al. (2006) calculates that 20% of U.S. dollars used to buy additional imports of oil return to the country as the Middle East imports more U.S. goods. This impact may be relatively small considering that only about 16% of gross imports of oil to the U.S. come from the Persian Gulf, and the U.S. might not increase its exports as much to larger importers such as Canada, Mexico, and Venezuela (EIA 2008). Still, the trade deficit should increase (in the absence of changes to the dollar see next sub-section How an Oil Shock Impacts the Dollar), and such

27

an effect would normally lead to higher interest rates to attract new lenders. Yet it appears as though up to half of the money oil exporters gain from higher prices is invested back into U.S. treasury securities, reducing interest rates in the process by up to one-third of a percentage point (Rebucci and Spatafora 2006).9 If true, it is quite possible that interest rates actually fall during an oil price shock. Exports to the U.S. in 2007 only accounted for about 11% and 22% of Middle East and OPEC total exports (BP 2008; EIA 2008). But if half of new oil money is going to the U.S., it implies that more dollars are coming into the U.S. than leaving to purchase the oil. This increase in demand for U.S. securities would increase, driving down the yields and therefore, the interest rate. The immediate impact on the sustainability of deficit may also counter expectations because the value of foreigners investments can fall. In 2003, for instance, the IIP of the U.S. essentially remained unchanged despite a large trade deficit because the value of U.S. foreign assets increased significantly while the dollar depreciated (Helbling et. al. 2005). Industrial countries such as the U.S. tend to have assets denominated in foreign currencies. In the long-run, both potentially sanguine effects on the trade deficit and its sustainability could turn sour. It appears as though countries in the Middle East that were first cautious with their spending at the beginning of the oil price increase from 2002-2005 began spending much more of their money by 2008
9

According to Rebucci and Spatafora (2006) and Higgins et. al. (2006), it appears as though oil exporters in the Middle East use British intermediaries to buy U.S. securities in the most recent oil price increase of from 2002 to 2008. Economists cannot measure the origins of the purchases directly, but they know that the U.S.s trade deficit must be offset with a trade surplus somewhere. Although the surpluses in Asia were large, they were still smaller than those in the Middle East. These economists believe the countries in the Middle East use British intermediaries or lend to countries like Japan that then invest in U.S. securities, making an indirect investment with funds originating in the oil exporting countries.

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(Rebucci and Spatafora 2006; How 2008). Thus, less money would be available to buy U.S. treasuries, causing interest rates to rise with fewer foreign lenders. The trade deficit would probably not directly shrink much because the Middle East is only a small market for U.S. goods (Higgins et. al. 2006). Additionally, it cannot always be expected that the U.S. can continue to run trade deficits without increasing its risk. The positive valuation effects from declines in domestic asset prices or the dollar cannot be expected to continue indefinitely. Although the U.S. may be fine with a large trade deficit, doing so carries risks. Helbling et. al. (2005) note the possibility of abrupt changes toward rebalancing that can have significant impacts on macroeconomic variables. They say this potential is especially prominent during turbulent economic times such as during an oil shock.

How an Oil Shock Impacts the Dollar An oil shock should impact the value of the dollar, but the direction and magnitude is also unclear. A decline in the value of the dollar is likely the more desirable outcome because it would counteract the increasing trade deficit by making exports more competitive. However, a declining dollar may reduce the willingness of foreign governments with large dollar reserves to finance future U.S. deficits if the value of their dollar holdings decline. If these lenders move away from dollars toward a broader basket of currencies, interest rates could increase.

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In theory, an oil importer such as the U.S. should have a declining currency (Throop 1993). However, Benassy-Quere et. al. (2007) calculate that during the 1974-2004 period, the U.S. dollar tended to increase in response to a positive oil shock. But they argue that the dollar may now follow its theoretical pattern because it fell during the oil price increase of the 2002-2004 period, which some are attributing to the rise of China as a major oil importer. Yet the magnitude of this trend is questionable because many Middle East countries peg their currencies to the dollar (Petrodollar 2006). When oil prices rise, the currencies of oil exporters should also rise. Since the currencies are pegged to the dollar, the exporters need to purchase dollars, causing the dollar to appreciate. Assuming the dollar does fall during a shock, it would tend to reduce the trade deficit, although the magnitude of this effect is also quite uncertain. Ogawa and Kudo (2007) find a small effect, saying a 30% depreciation is needed to reduce the trade deficit by 0.7% of GDP, or only slightly larger than the magnitude the deficit is expected to rise after a unit shock. Yet Feldstein (2006) believes such a change in the dollar would reduce the trade deficit by a much larger value of more than 3% of GDP. Regardless of the exact magnitude, it appears as though a reduction in the value of the dollar is not guaranteed to offset the risks from a larger trade deficit. Risks of higher interest rates and a painful adjustment process to reduce the trade deficit remain.

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QUANTITATIVE IMPACTS ON MACROECONOMIC VARIABLES The values cited in this section are found in Appendix A: Data on Impacts of an Oil Shock. Effect on Unemployment Davis and Haltiwanger (2001) have the most comprehensive paper concerning the impact of an oil price shock on employment. They find a quite dramatic impact when looking at 4-digit Standard Industrial Classification (SIC) manufacturing labor data from 1972-1988. Also, the types of businesses affected seem to be more capital intensive and to a lesser extent more energy-intensive. Compared with their findings in the 1970s and 1980s, the employment impact today is likely much smaller. Edelstein and Killian (2007) find that employment losses from 1988-2006 are only about 1/5 of the magnitude they were from 1970-1987. This trend seems to be similar to that shown at the end of the Davis and Haltiwanger paper, which showed that the response when analyzing the 1972-1993 period was only 70% of what it was when the data set ended in 1988. Davis and Haltiwanger (2001) only analyzes manufacturing, but the impact on jobs in other sectors of the economy are likely relatively similar. The change in employment is probably closely tied to consumer preferences; if consumers change their preferences away from a given industry, that industry will probably suffer, resulting in job losses. An oil price shock impacts many service sector industries, including restaurants, airline tickets, and tourism, so job losses are bound to be in more sectors than manufacturing (Kilian 2008). In addition,

31

the original unemployment effect of Davis and Haltiwanger (2001) of 2.19 percentage points at its peak for the 1972-1988 period is very similar to the 2.32% impact in Edelstein and Kilian (2007) for the 1970-1987 period. (Note: All future references to percentage point changes to the unemployment rate, inflation, and interest rates will use the percentage symbol, %). Since they begin with very similar values, it seems reasonable to use a value similar to the more recent Edelstein and Kilian figure of 0.55% for the analysis. For the analysis, the assumption will be that the maximum rise in unemployment is 0.5% with a sensitivity analysis of between 0.25% and 0.75% for a unit oil price shock. This figure is generally in line with Annual Energy Outlooks prediction of about a 0.2% and 0.4% employment change in years one and two from a $20/barrel unit oil shock (AEO 2006). The actual value might be toward the lower end considering the difference between the two periods in Edelstein and Kilian (2007) may actually be part of a more continuous trend. Also, the rising energy prices of this most recent decade did not appear to substantially increase unemployment.10 The duration of the unemployment and the total reallocation are also important in order to determine how long people were unemployed and how many are likely to feel its long-term effects. Davis and Haltiwanger (2001) provide good guidelines for these two questions. Assuming 0.5% is the maximum increase in unemployment seven quarters after the oil price shock, the increase in

10

However, the unemployment rate during the Bush Administration was not as low as it was in the 1990s under Clinton when oil prices were lower and had smaller fluctuations. Some commentators have described the recovery after the 2001 recession as jobless, and it is possible that increases in oil prices contributed. (Groshen and Potter 2003).

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unemployment in quarters 3, 11, and 15 will be 0.05%, 0.25%, and 0.11%. All of this unemployment is assumed to last one year, although this technique may slightly underestimate the impact considering the greatest increase in unemployment occurs in quarter 4, and many of those people are still unemployed nearly one year later in quarter 7. As for reallocation, the maximum impact is about 1.5 times greater than the maximum unemployment, so the reallocation is assumed to be 0.75% for a unit oil price shock. This analysis will not include the reduction in unemployment volatility that Wolfers (2003) argues reduces well-being in addition to higher unemployment itself. It would be difficult to know how the unemployment rate would change in the absence of oil price shocks. As Hamilton (2008a) notes, oil price increases have preceded nine of ten recessions since WWII, and recessions are major sources of unemployment volatility. Yet some recessions with attendant unemployment volatility would almost certainly have occurred in the absence of oil price shocks. The upper end of the unemployment sensitivity analysis can help account for the volatility.

Effect on GDP A large body of work has analyzed the impact of an oil price shock on GDP. Most of the analyses of the effect on GDP are calculated in terms of the elasticity of GDP given the price of oil (Jones et. al. 2004). In order to make them relevant to this paper, these elasticities must be converted into the effect of a unit

33

shock. A constant elasticity has limited importance because it would tend to give too much (little) weight to price changes at low (high) oil prices. Many papers find an elasticity of about -0.055 (Jones et. al. 2004). Most of these papers focus on the oil shocks between 1973 and 1990. Given that the real average monthly oil price from 1973-1988 was over $51, and the average price from 1973-1993 is over $45, an average price of $50 is assumed (EIA 2009b). Thus, a $20 oil shock is a 40% increase. A GDP elasticity of -0.055 would indicate an impact of about -2.2% in terms of GDP. Yet as Edelstein and Kilian (2007) and Hamilton (2008a) argue, the impact of oil prices on GDP as well as other macroeconomic variables has declined significantly since the 1970s, biasing this calculation strongly upward. The effect on unemployment since the late 1980s seems to be about 20-25% of what it was in the 1970s, and the effect on GDP is likely relatively similar. More specifically, the effect of an oil price change on real consumption and real residential fixed investment in the 1988-2006 period are only 26% and 28% of what they were from 1970-1987 (Edelstein and Kilian 2007). Assuming the effect is 27% as large as it was previously leads to an impact of -0.6% for GDP from a unit shock. This effect shows the maximum shock rather than the trajectory of the shock, which is what consumers would feel. Using Figure 2.2, it is possible to see that the largest impact occurs in quarters three to five after the shock. The graph shows a maximum impact of about -0.55% and an average impact over the five quarters with a negative effect of -0.33%. In other words, the average impact is

34

about two-thirds of the value of the maximum, so the average effect on GDP from a unit shock is calculated to be -0.4% for five quarters.

Figure 2.2: GDP Response to an Oil Price Shock

Source: Sill 2007 This paper employs a sensitivity analysis for each of the variables that are uncertain. For the sensitivity analysis in regards to GDP, the lower value will be half of the midpoint calculation, or -0.2% of GDP for five quarters. The upper bound uses the models from the Annual Energy Outlook, which show an impact in years one and two of about -0.5% per year (AEO 2006). It should be noted that the effect on GDP seems to be conditional on many factors including the presence of existing business problems, the response of the Federal Reserve, and the source of the shock. Hamilton (2008a) notes how an oil price increase although not necessarily a shock preceded nine of the ten recessions since WWII, so an oil price increase may accelerate or unleash downturns in the business cycle and therefore have more of an impact than is calculated in this paper. The Federal Reserve, in an attempt to control inflation,

35

might sacrifice growth in the presence of higher interest rates. Finally, if the source of the shock is due to increased demand rather than a supply shortage, it is possible that there will be no negative GDP impact at all. The increased demand could boost GDP to a larger extent than the high oil price retards it (Kilian 2008).

Effects on Inflation and Interest Rates An oil price shock should tend to increase both inflation and interest rates. They are discussed together because they are very well-correlated, and the data on interest rates are somewhat sparse. Welsch (2007) finds a correlation between the two variables of over 0.84, by far the highest correlation of any two macroeconomic variables.11 Higher inflation is one of the first impacts of an oil shock, but much of the initial increase is the same as an income effect from higher oil prices. Oil is part of a basket of goods a consumer purchases. As the price of oil rises, overall inflation increases. Oil also has the potential to lead to spillover inflation, which is its inflationary impact on other parts of the economy (Chen 2009). However, Van den Noord and Andre (2007) find that this spillover effect into core inflation that excludes volatile commodity prices is much smaller today than it was in the 1970s. They speculate that this decline may be due to a change in monetary policy in the U.S. toward keeping inflation low beginning with Fed Chairman Paul Volcker in the early 1980s and increasing trade openness that

11

The next closest is between growth and inflation, which is -0.36. The correlation between inflation and interest rates is likely quite high because the interest rate is a nominal figure that should take inflation into account. The correlation may not be quite as high during an oil shock, but they do interact.

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allows for inexpensive goods to flow into countries and counteract inflationary pressures. Overall, Chen (2009) provides the most comprehensive analysis of the impact of a shock on inflation. He calculates that the inflationary impacts of a shock have declined significantly for most developed countries since the 1970s. Since 1981, he finds a short-term elasticity of inflation of 0.0028, which means a unit shock starting at $50/barrel would only increase inflation by 0.1 percentage points. He finds that long-term inflation would increase more by over 1%. Other sources find impacts of between 0.4% and 1.0% (Cologni and Manera 2008; AEO 2006). Like inflation, interest rates are likely to rise, but the changes can come from a variety of sources.12 Overall, even if real interest rates remain constant, they will necessarily have to increase in nominal terms to keep pace with inflation. Additionally, if the Federal Reserve chooses to counteract potential inflationary pressures, interest rates will rise. Tied in with monetary policy, there may be a liquidity preference as people rebalance portfolios, and if the Fed does not meet growing money demand, interest rates will rise (Cologni and Manera 2008) Unfortunately, there are relatively few accessible quantitative estimates of a shocks impact on interest rates. Two papers only present graphs that are quite difficult to discern (Gronwald 2008; Huang et. al. 2005). Cologni and Manera (2008) do provide an estimate specifically for the 1990 shock, finding an increase

They are likely to rise from domestic pressures. An influx of capital from oil exporters may keep them down.

12

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of about 0.4% for a unit shock. The effects seem to essentially end once the oil shock is over. The effects on both inflation and interest rates are quite uncertain, with a range of 0.1%-1% for inflation and one data point of 0.4% for interest rates. The sensitivity analysis will take this great uncertainty into account, ranging from 0.1% to 1.4%. The midpoint will be 0.5%.

UNCERTAIN NATIONAL SECURITY RISKS (AND BENEFITS?) Higher oil prices have the potential to strengthen autocratic regimes of oil exporters such as Iran, Venezuela, and Russia. In an oil price shock, Hugo Chavez of Venezuela and Mahmoud Ahmadinejad very likely have more leeway to bluster and complicate the foreign policy of Western nations because they have more resources they can use to build support domestically. However, an increase in oil prices in some ways may benefit U.S. security. As of 2005, Saudi Arabia had an unemployment rate of perhaps 20%, and The Economist notes how unemployed young men are prime targets for extremists because they are disaffected and seem hopeless (Recycling 2005). With oil money, the Saudi economy can potentially try to develop jobs for them. Similarly, Jones (2009) explains that the Saudi royal family only began supporting more extreme clerics once again in the 1990s as a way to build support when there was a lack of oil money, also demonstrating how there may be a positive relationship between oil prices and security.

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Because of the uncertainty of these impacts, they will be ignored for this analysis. Additionally, it should be noted that U.S. oil policy is limited in what it can do about security risk. The price of oil is global, and if there is an oil shock, oil exporters get revenue from around the world. While it is possible that U.S. policies to reduce oil consumption or increase supply may lower prices or diminish some of the impact of a future shock, these outcomes are much less certain than the fact that the impact of a given future oil shock should be reduced with these policies. This paper is based on the view that an oil shock is likely in the future because of a whole host of problems related to political instability, resource access, and demand growth that the U.S. can influence but not control.

BENEFITS FROM REDUCED DRIVING AND FUEL CONSUMPTION Higher prices should lead to reduced demand for oil. Immediately after a shock, much of the change should come from reduced driving. However, some families with multiple vehicles can switch to their more efficient vehicle, reducing consumption without changing their behavior. Consumer preferences for new vehicles should also move toward more efficient vehicles, leading to an improvement in efficiency that should last for the entire lifetime of the vehicle. Reduced driving should reduce the number of traffic deaths. It should also reduce traffic congestion, which should shorten commuting time to work. Lower oil consumption should improve local air pollution and reduce emissions of greenhouse gases (GHGs) that contribute to global warming. Reduced driving may also benefit air pollution in certain urban areas with less traffic congestion.

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As a first-order approximation, each of these impacts should be proportional to the decrease in vehicle-miles traveled (VMT) or gasoline consumed. The overall price elasticity of gasoline demand was between -0.034 and -0.077 between 2001 and 2006, and the elasticities oil demand are quite similar to those for gasoline (Hughes et. al. 2008; Hamilton 2008b). Again assuming a $50/barrel starting price that increases $20/barrel, these elasticities imply a short-term reduction in oil consumption of between 1.4% and 3.1% with an average of 2.25%. Reduced driving is only a portion of this reduction. Assuming that half of the reduction comes from fewer VMTs, the short-term reduction in driving is between 0.7% and 1.5% with an average of 1.1%. However, a simple proportion between reduced VMT or oil consumption and the associated benefits do not seem appropriate in all circumstances. Benefits to traffic congestion and GHGs could be less than the reduction in driving or oil use would indicate. Yet impacts to traffic deaths and air pollution may be greater than proportional.

Commuting Time With reduced driving, traffic should decrease, allowing people to get to work quicker than they otherwise would have. However, it is quite possible that the effect will be smaller than the percentage reduction in VMT if people reduce pleasure trips or combine trips for errands more than they reduce driving to work. Additionally, commuting time can only be reduced by a limited amount because there is a minimum time needed to travel in the absence of traffic; the minimum

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time should be the distance traveled divided by the speed limit. On the other hand, the impact of reduced driving could have more than proportional effects in certain places if the reduction of a few cars on the road leads to significantly higher road speeds. These different possibilities will spread the sensitivity analysis from 0.4% to 2% because the effect has greater uncertainty. The midpoint for VMT reduction of 1.1% will stay the same. In 2005, the average one-way commute was 25.1 minutes (AP 2006). With this reduction in VMT, the average reduction in one-way commuting time should fall between 6 30 seconds with a midpoint of 16.5 seconds.

Traffic Deaths Reduced VMT should also result in fewer traffic deaths. Data from the increase in driving post-9/11 and the significant decrease in 2008 indicate that a reduction in VMT will have a greater than proportional impact on traffic deaths. For instance, Sivak and Flannagan (2004) find that traffic fatalities for drivers (who make up about 70% of traffic fatalities) increased 8.8% in the last quarter of 2001 (FARS 2008). Yet the increase in VMT during this last quarter was only 2.9% (FHA 2003). Similarly, while VMT in 2008 dropped by about 3.5-4%, fatalities dramatically declined by about 10% (NHTSA 2008). Part of this decline is due to a long-running decrease in fatalities per 100 million miles driven, which had fairly steadily decreased from 1.64 to 1.36 from 1997 to 2007 (FARS 2008).

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However, the drop in 2008 is so steep that it indicates that traffic deaths decline disproportionately faster than declines in VMT. Theoretically, it is possible that riskier drivers are the first to reduce (or after an incident like 9/11, increase) their driving (Sivak and Flannagan 2004). For this analysis, it will be assumed that driving deaths will decrease at twice the rate of the decline in VMT. Therefore, a unit shock will cause driving deaths to decline between 1.4% and 3% with a midpoint of 2.2%. In 2007, 41,059 people died in traffic-related incidents13 (FARS 2008). Therefore, between 575 and 1230 fewer people should die in traffic accidents with a midpoint of 905.

Air Pollution The burning of oil is responsible for the emission of many localized air pollutants such as particulate matter (PM) and ozone (O 3). These pollutants can reduce happiness by leading to a reduction in agricultural output, visual pollution in the form of haze, respiratory problems, and premature death (Krewski 2009). For this analysis, it will be difficult to measure those effects except for the reduction in expected life span (e.g. Pope et. al. 2009) Studies on how air pollution, particularly PM, affect life expectancy are quite well-developed. PM is the particular air pollutant from the burning of oil that appears to reduce life expectancy. The Environmental Protection Agency (EPA) has two classifications for PM based on the size of the particles PM2.5 and PM10 which represent particles that are under 2.5 micrometers and 10 micrometers in diameter

This number accounts for about 30,000 vehicle occupants and slightly more than 5,000 motorcyclists and 5,000 pedestrians/bicyclists.

13

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respectively. Pope et. al. (2009) finds that a reduction of 10 micrograms of PM2.5 per cubic meter increases life expectancy by 0.61 years +/- 0.20 years. Such a finding is relatively similar to the indirect approaches of other studies that measured the relative risk of dying and then applied the finding to actuary tables (Krewski 2009). In their reanalysis of the two major studies of air pollution, Krewski et. al. (2003) find that the relative risk of dying from PM pollution is relatively similar to that for sulfate (SO42-). Yet almost all of the sulfate pollution comes from electric power plants, very few of which use oil (EPA 2002). PM2.5 can be directly emitted, which is known as primary emission, but most of atmospheric PM2.5 is from the emission of precursors or secondary particles. These particles include criteria pollutants as defined by the Clean Air Act such as sulfur dioxide (SO2) and volatile organic compounds (VOCs) (EPA Basic 2008). On-road vehicles directly contribute to PM2.5 with road dust, and they were responsible for 25% of VOCs as of 2000 (EPA 2002). Although the composition of the PM can affect the health impacts, it is generally acceptable to group PM from any origin together (Bell et. al. 2008). The national mean level of PM2.5 in 2007 was 11.9 micrograms per cubic meter, so if there were no PM2.5 emissions at all, it could be expected that life expectancy would increase about 0.73 years (EPA 2008).14 However, not all of these emissions are from oil. A reasonable estimate could assume that 40% PM

This technique may somewhat underestimate the effects of reducing emissions. Even low levels of emissions are responsible for health problems, and data suggest that citizens in areas with low levels of PM2.5 pollution may experience a boost in life expectancy effect greater than 0.61 years/10 microgram reduction (Pope et. al. 2009).

14

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emissions are from oil; oil provides about 40% of total U.S. energy (EPA 2009). Forty percent is also in between the percentage of total emissions of local air pollutants such as carbon monoxide from on-road vehicles (~55%) and nitrogen oxides (~35%) and VOCs (~25%) (EPA 2008). With this estimation technique, if all oil use were stopped today, life expectancy would increase 0.29 years. However, the reduction in air pollution from an oil shock is not longlasting unless it leads to a significant change in the type of vehicles purchased.15 Given that an average person lives about 80 years, a one-year change in PM2.5 would increase life expectancy by 1.3 days (SSA 2004). Finally, the actual reduction in PM2.5 emissions from a price shock should be the reduction in oil use with a slight increase to account for the reduction in traffic congestion for some areas. Adding the reduction in oil use with reduced VMT would imply a reduction of between 2.1 4.5% per year of air pollution from oil with a midpoint of 3.3%. Such a decrease would imply an increase in life expectancy of between 40 85 minutes per person with a midpoint of slightly over one hour for a unit oil shock lasting one year. Actually assuming an increase in life expectancy of about an hour may seem almost comical, but it can be significant when calculated over the entire population. This impact may be biased downward because it does not include health impacts such as increased hospital visits and reduced health outcomes from greater respiratory ailments. It should be noted that this calculation contains many uncertain assumptions, so it should be used as a general guide for the order
15

An oil price shock may have an impact on sources of energy such as electricity that also emit pollutants, but the direct impact from reduced oil use is probably the most significant. Kilian (2008) and Edelstein and Kilian (2007) have estimations of cross-elasticities.

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of magnitude of the effect of reduced localized air pollution rather than treated as a precise estimate.16

Emissions of Greenhouse Gases In general, the reduction in oil consumption and increased efficiency of new vehicles purchased should reduce greenhouse gas emissions (GHGs) that contribute to global warming. However, higher prices can also lead to more exploration of new sources with higher GHGs such as tar sands in Canada, and it can increase the popularity of sources with many other externalities such as corn ethanol and fuel from palm oil (Kockleman et. al. 2008). Due to this uncertainty to even the direction of the effect from an oil price shock, it will not be included in the calculation. Chapter 3 has a discussion of the difficulty of calculating GHG impacts, especially as they relate to a framework based on happiness.

OVERALL IMPACTS Table 2.2 on the following page summarizes the quantitative information in the chapter for easy access. The last column lists whether the estimates given in the chart may be underestimated or overestimated. For instance, the income figures are potentially underestimated because they do not take into account that people may have needed to borrow money to pay for the fuel.

Additionally, the largest reductions in air pollution have come from tightened vehicle standards for local air pollutants, which significantly impacts the calculation presented here (EPA 2008).

16

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Table 2.2: Quantitative Estimates of Impacts from Unit Shock Effect Unit MidLower Upper Figures Possibly point bound bound Underestimated or Overestimated? Income Dollars -201 N/A N/A Underestimated: If st change 1 lost per needed to borrow quintile year Income Dollars -337 N/A N/A Underestimated:: If change 2nd lost per needed to borrow quintile year Income Dollars -453 N/A N/A Underestimated:: If rd change 3 lost per needed to borrow quintile year Income Dollars -564 N/A N/A Underestimated: If change 4th lost per needed to borrow quintile year Dollars -702 N/A N/A Underestimated: If Income th lost per needed to borrow change 5 quintile year (rarer for this group) Employment Percent in -0.05, - 50% of 50% Overestimated: Job years 1-4 0.5, midhigher losses from oil -0.25, point than shocks may have and mid continued to 0.11 point decline Job Percent in -0.75 -0.375 -1.125 Overestimated: Job Reallocation years 1-4 losses from oil shocks may have continued to decline GDP Percent -0.4 (5 -0.2 (5 -0.5 (2 per year quarter) quarter) years) Inflation and Percent 0.5 0.1 1.4 Interest Rates per year Quicker Seconds 16.5 6 30 Overestimated: Commute each way Traffic Reduced Number 905 575 1230 Traffic Deaths Air Pollution Increased 62 40 85 Underestimated: Lifespan Unable to account (minutes) for health impacts for those alive

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Chapter 3: Measuring Happiness We hold these truths to be self-evident, that all men . . . are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty, and the pursuit of Happiness - Thomas Jefferson, Declaration of Independence (1776) Economists have tried to maximize utility, and this chapter shares this goal. As Kahneman et. al. (1997) explain, economists have used decision utility, researching what decisions individuals make in order to discover what maximizes utility. However, this approach has substantial limitations that an analysis of an oil shock makes quite clear. An oil shock changes so many variables microeconomic, macroeconomic, trade, environmental, and traffic-related. An approach focusing on decision utility has difficulty weighing the importance of the relative components and finding what impacts of an oil shock are most detrimental or beneficial. While it is possible to use a decision utility framework to try to estimate specific benefits and costs, the process is extremely uncertain and inadequate. One would assume a declining marginal utility of income, but trying to value how an income loss affects people of different income and how people adapt is quite arbitrary and subject to ideology. The impact of unemployment on well-being would require questionable proxies such as a look at increased use of products and services used for coping with stress such as alcohol, cigarettes, and psychological counseling. However, the unemployed have less money to spend on these products, making a valuation even more complicated. Additionally, it is

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essentially impossible to identify losses from changes to GDP, inflation, and interest rates in addition to a loss of income. Decision utility is somewhat more useful for the positive impacts of an oil shock. Various methods such as contingent valuation can be used for air pollution. Economists have also calculated a statistical value of a life and the monetary impacts of traffic congestion (Frey and Stutzer 2005). These effects are put in terms of dollars, which is problematic because a dollar does not have the same value in every context. A declining marginal utility of income assures that a dollar to a poorer person should have more value that it does to someone of greater means. In contrast, this paper uses subjective well-being (SWB) surveys that ask residents to rate their happiness or life satisfaction. Contrasting it with decision utility, Kahneman et. al. (1997) call this approach experienced utility, and it directly gauges how people feel about their lives. Economists have then taken the hundreds of thousands of responses since the 1970s and have calculated the direct impacts on happiness of income, unemployment, other variables discussed in this paper. These calculations directly measure the impact of particular changes without requiring complicated and quite dubious proxies. Just as economists currently try to create utility functions, these economists create happiness or life satisfaction equations, assuming that these feelings are dependent on various situational factors. Some may be uneasy using measures of self-reported happiness to make policy, but as Jefferson wrote in the Declaration of Independence, happiness is

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fundamental to the goals of America. Maximizing happiness and utility were central to the ideas of 19th century Utilitarian philosophers such as Jeremy Bentham and John Stuart Mill, and their ethics live on in modern economics (Frey 2008). Since their time, the scientific study of happiness has advanced greatly, allowing governments to figure out what policies can maximize the happiness of its residents. By calculating the benefit of reducing oil use in terms of happiness, this paper provides half of the information needed for what has been described as a life satisfaction cost-benefit analysis (LS-CBA) (Diener and Seligman 2004; Frey and Stutzer 2005). The data in this chapter could be used to help analyze the costs of various policies to reduce oil use such as a fuel economy standard, completing the LS-CBA. Diener and Seligman (2004) believe that such an approach can be used in tandem with more traditional metrics such as the unemployment rate and changes in GDP to provide a more complete picture of how to address policy questions. At this time, it appears that no comprehensive quantitative guide to how various changes affect happiness or life satisfaction has been created that would facilitate a LS-CBA, and none of these cost-benefit analyses has been conducted for any policy. Layard (2005) and Frey (2008) have gone the farthest by making some general suggestions for public policy based upon the surveys, but they do not complete a LS-CBA.

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BACKGROUND ON SUBJECTIVE WELL-BEING SURVEYS The Subjective-Well Being Surveys Hundreds of thousands of citizens have taken SWB surveys. They strongly differ from traditional economic techniques that solely look at the decisions of individuals (Frey and Stutzer 2005). The term SWB will be used throughout this paper interchangeably with happiness. At various times, specific surveys that ask about either happiness or life satisfaction will be identified. The surveys ask similar questions, but more focus on life satisfaction than happiness. The U.S. is different from European nations in that the U.S.s survey focuses on happiness only. The Eurobarometer did ask a happiness question from 1975-1986 that closely mirrored the U.S. question, but the survey apparently no longer asks it (Di Tella et. al. 2001). The following questions are listed in Layard et. al. (2008): United States General Social Survey (USGSS happiness): Taken all together, how would you say things are these days? Would you say you are very happy, pretty happy, or not too happy? (Effective scale 1-3) Eurobarometer (happiness): Taking all things together, how would you say you are these days would you say youre very happy, fairly happy, or not too happy these days? (Effective scale 1-3) Eurobarometer (life satisfaction): On the whole, are you very satisfied, fairly satisfied, not very satisfied, or not at all satisfied with the life you lead? (Effective scale 1-4. )

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German Socio-Economic Panel (GSOEP life satisfaction): In conclusion, we would like to ask you about your satisfaction with your life in general. Please answer according to the following scale: 0 means completely dissatisfied, 10 means completely satisfied. How satisfied are you with your life, al things considered? (Actual scale 010)

These surveys have each been asked to at least tens of thousands of people. The Eurobarometer even has more data points, with information on over 250,000 Europeans from 1975-1991, meaning that the survey has probably reached about half of a million people by now (Di Tella et. al. 2001). The GSOEP tracked some of the same people over a period of more than one decade, allowing a long-term view of the impacts and adaptation of individuals to major life events such as marriage, death of a family member, and unemployment (Lucas 2007).

The Reliability and Usefulness of SWB Surveys Researchers have found strong correlations between self-reported happiness and life satisfaction and a whole range of other outward signs of those emotions. Blanchflower and Oswald (2004) document many of the correlations such as persons recall of positive vs. negative life events, assessments of persons happiness by friends and family, duration of authentic Duchanne smiles, heart rate and blood pressure and skin-resistance response to stress, illnesses like digestive disorders and headaches, and measures of pre-frontal brain activity.

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Frey and Stuzer (2005) defend the surveys on the basis that these measurements over the past 35 years have become quite sophisticated. Traditional economists shied away from self-reported well-being because they did not believe the results could be trusted. Yet tests of the surveys demonstrate that individuals report similar levels of happiness a few weeks apart, showing that those who take the surveys properly interpret them to be asking how happy they are in their lives as a whole rather than how they feel on a particular day (Eid and Diener 2004; Krueger and Schkade 2007). Considering that hundreds of thousands of people have taken the surveys, it is possible to quite reliably measure the impact on well-being of relatively small changes in individual circumstances such as a change in income or broadly measured variables like the unemployment rate. The surveys are also becoming more generally accepted in the economics community, and many economists are now going to conferences on SWB (Diener and Seligman 2004). Other types of indicators have been proposed, but they are not as helpful for this paper as a straightforward measure of well-being. One of the most famous is the World Development Index, but it primarily shows differences among countries in different stages of development on such metrics as literacy and child mortality and would not give a straightforward indication of the impacts of an oil price shock (McGillivray 2005). Another metric that has received a lot of attention is the Gross National Happiness measurement from the small Himalayan country of Bhutan. While the concept of maximizing national happiness is central to this paper, GDH includes concepts such as preserving

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cultural values that are difficult to measure, and it does not rely on self-reported happiness (Mustafa 2005). Samman (2007) proposes a complicated system that includes meaning in life, relatedness, autonomy, and competence in addition to life satisfaction and happiness. For the U.S. in particular, Diener and Seligman (2004) argue for a national well-being index that analyzes positive and negative emotions, purpose and meaning, optimism and trust, and a broad construct of life satisfaction. As a long-term goal, it might be more accurate to try to maximize such a comprehensive index of well-being rather than just happiness or life satisfaction, but it would be extremely difficult to use something like it in this paper. Many of these terms are not well-defined, few if any economists have looked at the impact of changes to life and economic circumstances to many of these concepts such as purpose and meaning, and it is unclear how to weight each of these components in a given index.

How SWB Surveys are Used in This Paper The USGSS and Eurobarometer use word-based answer choices such as not too happy rather than numbers, but economists studying the surveys have translated those words into numbers. Therefore, in the USGSS, very happy is given the value of three, while pretty happy and not too happy become the numbers two and one respectively. The surveys used in this paper also have different scales for measuring SWB three, four, and eleven answer choices. They are all normalized to a fourpoint scale because much of the data about macroeconomic variables are from the

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four-point Eurobarometer life satisfaction survey. It should also lead to the least distortion when trying to translate survey answers to this common scale. Thus, the USGSS and Eurobarometer happiness question responses are multiplied by 4/3, and the GSOEP are multiplied by 4/11. Layard et. al. (2008) uses a similar technique but chooses to normalize with the 11-point GSOEP scale.

Potential Problems with SWB Surveys Life satisfaction and happiness clearly can lead to different responses. From a theoretical standpoint, it might be that life satisfaction is more connected to status, while happiness might be somewhat more fleeting and influenced by more tangible goods and income.17 However, psychologists and economists in this field emphasize that the two questions are similar; Di Tella et. al. (2001) find that the correlation between the responses to the life satisfaction and happiness questions was 0.56 from 1975 to 1986, when the Eurobarometer asked both questions together. In this paper, there are small differences between the two measurements in the cases of income and unemployment, but they have little effect on the paper because the U.S.-specific data on happiness can be used. Additionally, it is unclear whether the transformations up from three to four and down from 11 to four are perfectly accurate. It is possible that it could overstate or understate the effect. For instance, transforming the effect from an 11-point to four-point scale may understate the effects because it is doubtful that
Happiness is a central positive emotion that could derive from any source, whereas life satisfaction appears as though it could be mistaken for being proud of ones success. It could also have a bias toward ends that society deems important but do not actually make one feel better. Life satisfaction is more cognitive, asking someone to assess how they feel about what theyve done rather than directly getting at how they feel.
17

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many people use the extremes of 0 or 10, while many people chose the extreme categories on a four-point scale of very satisfied and not at all satisfied. Although perhaps less probable, the possibility exists that an 11-point scale may overstate certain effects, especially if they are small, because a disproportionate number of people may be compelled to report them on an 11-point scale who would not report them if they only had four choices to choose from.

EFFECT OF INCOME CHANGES TO SWB A Given Loss is Worse than a Given Gain and Adaption to Income Changes Higher income leads to greater happiness, although researchers have found decreasing marginal utility as income rises. For this paper, the most important finding is that a given immediate decline in income is five times worse than a long-term increase in income of the same amount (Di Tella et. al. 2006).18 Other sources have tried to figure out the risk aversion of individuals, and their findings generally appear to corroborate the 5:1 ratio. As part of their pioneering work with Prospect Theory, which predicts that individuals are riskaverse, Tversky and Kahneman (1992) find that a given loss is generally about twice as bad as a given gain. However, this 2:1 ratio compares an immediate gain and an immediate loss. The 2:1 ratio can be reconciled with the 5:1 ratio because Di Tella et. al. (2006) find that an initial income gain provides about three times the level of happiness as it does after four years once the individual adapts to the income change. Thus, combining these two findings indicates that a given short-

As they explain it after analyzing GSOEP data, individuals who experience an income loss of 21% of a standard deviation (SD) react as if they have lost one entire SD.

18

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term loss is six times worse than a given long-term gain, quite similar to the 5:1 ratio. It is possible that poorer individuals are even more risk-averse than this 5:1 ratio that compares a short-term income loss with the same long-term income gain. Shaw (1996) documents that more highly-educated individuals are more likely to take risks, and income is correlated with risk taking.19 Di Tella et. al. (2006) also note that their data suggest that negative changes are worse for poorer individuals. The data on risk-aversion become more scattered with researchers who look at the risk aversion of individuals in situations other than income. Various studies have looked at large gambles on wealth, unemployment search-efforts, the equity premium of investors, and deductible choices of homeowners to find risk aversion coefficients of five, seven, more than 10, and more than 100 respectively (Koszegi and Rabin 2007). Yet none of these directly analyzes the effect of income changes, which makes using them questionable for the purpose of this analysis. At this point, no source appears to analyze adaptation to an income loss, which could lead to a paradox with an oil price shock. If a sudden income loss is twice as bad as a sudden income gain, it would be possible that an individual would recover only of the happiness loss if oil prices go back to their original levels after the shock. In other words, if a loss of $1,000 per family across a large

It should be noted that she looked at the converse of my question. She found that people who are more risk-seeking get higher incomes, especially when they are highly educated. Therefore, it seems likely that individuals who have higher incomes are less risk-averse, but this hypothesis is not certain.

19

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population leads to the loss of 10 utils but gaining $1,000 from that income level only results in a gain of five, has the group still lost five utils even after the oil price shock has ended?20 This effect is possible if consumers feel increased uncertainty about their income. If this paradox is true to some extent, it would lead to an underestimation of the negative SWB impact from income in this paper.

Calculating How SWB Relates to Income Changes The first step in the calculation is to figure out the magnitude of happiness changes from increases in income by household income quintile controlling for a host of demographic and circumstantial characteristics. For this analysis, happiness data from the U.S. are used, although other data from Europe are shown in Appendix B: Subjective Well-being Data (Di Tella et. al. 2003). Appendix B also includes data on how changes to macroeconomic variables affect SWB. Relative income has been shown to substantially affect SWB, but it will be excluded from this paper (Layard 2005). It is assumed that people who use less than an average amount of fuel will be balanced by those who use more. If relative income does have an independent impact, its direction is uncertain. It depends upon whether the magnitude of the happiness change for drivers of efficient vehicles due to their relatively smaller income loss is greater or less than the magnitude of the happiness change of inefficient vehicle owners who have less relative income during a shock.

20

The util in this chapter is not defined as a mathematical concept. In Chapter 4, a Util is actually defined for use with calculations.

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In order to use the data on the effects of income changes to absolute income, it is necessary to figure out the slopes at the midpoints of each quartile to discover the additional happiness benefit from increasing by a standard percentile of income. For instance, on a 1-4 scale, an increase in income from the first quartile to the second quartile is 0.21, so it is assumed that increasing from having an income higher than 12.5% of households to higher than 37.5% of them will increase ones happiness in the long-term by that amount. Yet the quartile data must be converted into changes by quintile because income data from the US Census Bureau are grouped by quintile. To do so, it is assumed that the quintile difference is actually only 80% of the quartile difference. The U.S. data show a very similar increase in happiness from moving from the second to the third quartile as from moving from the third to the fourth. Thus, the increase in happiness levels off. The calculation is that moving from the first to the second quintiles and so on is 0.18, 0.14, 0.13, and 0.13. These numbers are then slightly converted to represent the change at the midpoint of each quintile (i.e. at 10% of income, 30%, etc.) rather than the midpoint between the quintiles (20%, 40%, etc.) so they represent a median household in each quintile. These figures are 0.195, 0.158, 0.133, 0.125, and 0.125.21 These numbers are all long-term gains, and they must be converted into short-term losses, which means that they are all multiplied by five. If the income loss last longer than one year, it will be assumed that an income loss has the same adaptation effect in percentage terms as an income gain a decline of importance

21

For instance, the values at 20% and 40% of income are 0.18 and 0.14 respectively, so it can be estimated that the values for 10% and 30% are 0.20 and 0.16, decreasing by 0.02 per 10%.

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of 40% in the first year that increases to two-thirds in three years (Di Tella et. al. 2006). Thus, if somebody falls from having the median household income to having an income that is higher than only 30% of the total population, it will be expected that their happiness would decline from the baseline level by about 0.67 (five times 0.133) in the first year, 0.40 in the second year and level off at a decline of 0.22. Finally, for ease of use, the table below shows the impact on SWB for each quintile in the first year given a sudden $1,000 loss. This table clearly shows a decreasing marginal utility of income that economic theory predicts.

Table 3.1: How a $1,000 Loss Affects SWB by Quintile Income Positive Negative Impact Income Quintile Impact at for Immediate Change Midpoint for Loss (Five times Needed for One Quintile previous column) One Quintile Gain Impact 1 (lowest) 0.195 0.975 $16,885 2 0.158 0.79 $17,760 3 0.133 0.665 $24,871 4 0.125 0.625 $80,877 5 0.125 0.625 $175,000*

Immediate SWB Effect of $1,000 Loss -0.058 -0.044 -0.027 -0.0077 -0.0036

These values are calculated by looking at the differences between the medians of the quintiles. For instance, this difference between the first and second quintiles is about $17,000, while the difference expands to almost $86,000 between the fourth and fifth quintiles (BLS 2008). Of course, no such number can be found for the fifth quintile because it is impossible to get to a higher quintile from the top. For this paper, the difference between the fourth and fifth quintile (about $81,000) was multiplied by the ratio of income between the fourth and fifth (about 2.15) to get a value of $175,000.

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Two different sensitivity analyses will be performed. One will simply increase the increase and decrease the midpoint by 25%. This will account for any difference between happiness and life satisfaction equations. It appears as though the change using the U.S. happiness scale is a little over 20% larger than the SWB impact from using European life satisfaction surveys (Di Tella et. al. 2001; Di Tella et. al. 2003). The high end of the sensitivity analysis can partially account for the possibility that income declines have longer-term impacts even when income rises back to original levels. The other sensitivity analysis will assume that lower-income individuals are more risk-averse than those with higher incomes. An immediate income loss will be considered seven times worse than a long-term gain for those in quintiles one and two, but it will be only three times worse for those in quintiles four and five.

EFFECTS OF EMPLOYMENT ON SWB Oil price shocks affect many macroeconomic variables, including unemployment, GDP, inflation, and interest rates. Of the four, changes to employment are the most complicated. Welsch (2007) is the only source that combines all four macroeconomic variables and looks at the impact on happiness from all of them concurrently. He finds that inflation actually becomes insignificant when the other three are considered, but some of his results seem questionable, especially in terms of the importance of the interest rate. Therefore, quantitative estimates of the effect on happiness rely heavily on other papers.

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Employment changes affect happiness in five major ways, three of which are relevant to the individual, and two of which concern all people in the population. On an individual level, losing ones employment immediately impacts ones SWB, but there are also long-term effects of losing a job that are apparent years after one has found another job (Lucas et. al. 2004). Losing ones employment can also be associated with a loss of health insurance in the U.S. For the population at large, a higher unemployment rate also reduces happiness, a phenomenon Di Tella et. al. (2001) attribute to a kind of fear effect in which individuals feel, in many cases rightly, as though they have less job security because more people around them are losing their jobs. Finally, Wolfers (2003) claims that unemployment volatility also reduces happiness, although this impact will not be included in the final calculation.

Short-term and Long-term Happiness Impacts of Becoming Unemployed The magnitude of the individual effect of losing ones job is quite dramatic, generally equivalent from falling from the top quartile of the income distribution to the bottom (e.g. Di Tella et. al. 2001; Welsch 2007). Quite a few studies have looked at the impact of being unemployed, and the data are relatively similar. Di Tella et. al. (2003) use happiness data from Europe and the U.S. on a three-point scale that translate to a change of about -0.5 on a four-point scale. This magnitude is somewhat larger than the effect that Lucas et. al. (2004) found when translated from the 11-point GSEOP scale to the four-point one used in this paper.

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The other major effect on individuals is a long-term reduction in happiness that occurs at least seven years after regaining employment (Lucas 2007).22 He finds no trend upward toward the baseline level even years afterward. In terms of the magnitude of the long-term employment effect, Lucas et. al. (2004) calculate that those who find new employment recover only two-thirds of the happiness they lost when they became unemployed. While the rationale for the long-term inability to return to ones previous level of happiness is somewhat unclear, a combination of a loss of dignity, changes in wealth, an increase in the sense of ones vulnerability, and reduction in the possibility of career advancement or achieving career goals likely accounts for a significant amount of the long-term effect.23 The estimate is that becoming unemployed will lead to a reduction in happiness of 0.45 on a four-point scale. Di Tella et. al. (2003) provides three estimates in terms of both happiness and life satisfaction between -0.50 and -0.52, but the somewhat lower figures reported in Di Tella et. al. (2001) and Lucas et. al. (2004) of slightly over -0.30 reduce the overall estimate. Di Tella et. al. (2003) has the only direct calculation of the change in happiness in the U.S. from an unemployment loss, which is measured at almost exactly -0.50 on a four-point scale.
To explain why life satisfaction drops in the year before the employment loss, Lucas et. al. (2004) argue that the it is likely indicative of a sense that ones job is in trouble. They generally reject the reverse causality possibility that the happiness loss leads to a reduction in productivity that precipitates a firing. They contend that if it were, there would probably be a downward spiral in happiness as the loss in income exacerbated the depression, but the data do not indicate as such. Increased fear of unemployment could have a positive impact in that it leads to greater productivity. 23 Lucas (2007) notes a wide variation in how individuals respond to unemployment and other major life changes. Nevertheless, means are reported in this paper to get a sense of the average response.
22

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In comparison, the long-term unemployment impact is -0.13 points per year. Lucas et. al. (2004) calculates that the long-term impact is one-third of the effect of losing a job. Yet his calculation for the effect of being unemployed is only -0.30, significantly lower than the average calculated. The value -0.13 splits the difference between his figure of -0.10 and -0.17, which would be one-third from the average calculated for this paper. However, this particular value of -0.13 per year is less important than the duration of the decline in terms of calculating the long-term happiness change associated with employment loss. For the calculation, seven years is chosen, which seems to show the long-term effects after the employment loss according to the data currently available. However, the long-term effect may be measured in decades until ones retirement or even death; only continued study can lead to an appropriate measurement.

Trying to Understand the Added Impact of Losing Health Insurance Another theoretical challenge involves understanding how the U.S. differs from Europe and whether changes in the last two decades have altered the impact of employment loss. As Di Tella et. al. (2003) demonstrate, the happiness impact of employment loss in the U.S. and Europe was very similar from the early 1970s to the early 1990s. From a theoretical standpoint, this may make sense considering that both locations have their own specific drawbacks to unemployment that might have made the experience equally bad. Hiring has traditionally been more difficult in Europe with stricter hiring and firing laws,

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while the U.S. has a less generous unemployment safety net (Di Tella and MacCulloch 2005). Yet compared with the 1972-1994 period, one could argue that becoming unemployed has become worse in the U.S. because of what strongly appears to be an increased risk of losing ones health insurance along with ones job. Back in 1977, only about 8% of unemployed workers lost their insurance along with their job (Kapur and Marquis 2003). They compare 1977 to 1996, when between 3040% of those who involuntarily lost their jobs with employer-sponsored health insurance were without health care 1-18 months after the job loss. Those numbers are likely even higher today given that the average family health insurance coverage was $12,680 in 2008 compared to only about $7,650 in real terms a decade earlier, or an increase of roughly 65% in real terms (Haynes 2009). A few studies have directly tied the unemployment rate with an increase in the number of uninsured. Gruber and Levitt (2002) found that an increase in the unemployment rate by 1% increased the number of uninsured by 1.2 million. An update of their work for 2009 has a similar estimate that an increase in the unemployment rate from 4.6% to 7% would lead to a decline in employersponsored insurance of 5.9 million and an increase in Medicaid and the State Childrens Health Insurance Program (SCHIP) enrollment of 2.4 million, for a net health insurance loss of 2.6 million or about a loss of 1.1 million per 1% increase in the unemployment rate (Holahan and Garrett 2009). Cawley and Simon (2005) have a somewhat lower estimate that an increase in the unemployment rate of 1.3% will lead to the loss of insurance for about one

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million individuals. Overall, the literature seems to indicate that a percentage point increase in unemployment is correlated with about one million people losing their health insurance.24 Unfortunately, it is difficult to quantify the magnitude of the happiness loss associated with losing ones health insurance. Most of the data used in the economic regressions of happiness are either relatively old or from Europe, where every country studied already has universal health coverage. The extent of the happiness loss could perhaps be very roughly estimated piecemeal from somewhat scattered sources. Freeman et. al. (2008) collect 14 studies concerning health insurance and health outcomes and find that not having insurance reduces self-reported health status and reduces overall health. Easterlin (2006) uses a bottom-up approach to overall happiness that includes health, and he concludes that health is significant but less important than family life, economic condition, and job satisfaction. Thus, whatever the magnitude of happiness loss associated with health insurance loss, it probably is smaller than that for losing ones job, at least initially. It is at least the magnitude of the premiums one spent on health care. This value is large but smaller than the effects of unemployment, which results in a SWB loss equivalent to falling from the top income quartile to the bottom. Losing ones health insurance and/or job may also shorten ones life expectancy, which has a profound impact on happiness as defined in this paper. As explained in a later section, undiscounted early death of one year would be the

24

An oil price shock that leads to economic uncertainty and/or reduced output might also cause some employers to cut health care benefits to employees who are still employed.

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equivalent of being unemployed for over six years. Most directly, since the loss of ones health insurance is correlated with lower health outcomes and reductions in preventative medicine, it also should shorten lives (Freeman et. al. 2008). Somewhat more arguably, happiness is a predictor of longevity, and since losing ones job reduces happiness for years, it may be correlated with a shorter life (Diener and Seligman 2004). Because these effects on health and longevity are so difficult to calculate, they will be left out of this analysis. Nevertheless, they could be incorporated in a sensitivity analysis recognizing that the calculated value for the happiness change from losing ones job might understate its long-term effects. The long-term effects of employment loss may also extend beyond seven years, implying an underestimation for this part of the calculation as well. Finally, the impact on the family members of one who loses his or her job might be more dramatic than the loss of income to the household would predict, further causing an underestimation. Overall, the potential loss of health care biases the estimation of the impact of the loss stemming from losing employment upward. The sensitivity analysis will be conducted from a loss of -0.30 to -0.60 with the estimation of -.45 at the midpoint. The upper value of -0.60 is higher than the highest calculation in any papers of -0.52, but it takes into account the increased potential to lose ones health insurance since 1972-1994, when the data were collected for the U.S. This potential for upward bias is also reflected in the sensitivity analysis for the long-term effects of unemployment. The duration will be between four and 14 years, even though the midpoint is toward the low end of the range at

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seven years. Thus, one who becomes unemployed will have long-term impacts on SWB of between -0.52 and -1.82 with a midpoint of -0.91.

The Population-Wide SWB Impact of a Higher Unemployment Rate An increase in the unemployment rate also appears to affect the population as a whole in addition to those who have lost their jobs. Di Tella et. al. (2001) attribute this decline to a fear effect of losing ones own job. Various studies have tried to analyze the impact of an increase in the unemployment rate in the long-term and as a result of a sudden change. The latter is more appropriate for this paper, but the data are not consistent as to which impact is larger. Thus, all estimates are used. Overall, it will be assumed that increasing the unemployment rate one point reduces the happiness of the average citizen by -0.024 points, which is the average of the five calculations in the literature (-0.01, -0.012, -0.019, -0.028, and -0.043).25 This estimation might be biased upwards to some degree considering that it is higher than three of the five calculations, and the -0.043 from Welsch (2007) is somewhat of a high outlier. However, this higher figure may better represent the increased fear in the U.S. of losing ones health insurance even in the absence of a direct job loss. The sensitivity analysis will assume that the range of possibility is between -0.01 and -0.043, the extremes of the estimations. The other population-wide impact is a result of unemployment volatility, which an oil price spike would exacerbate by relatively suddenly increasing

From Di Tella et. al. (2001), Wolfers (2003), Di Tella et. al. (2003), Di Tella et. al. (2001), and Welsch (2007) respectively

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unemployment in a period of a couple of years only to have it later fall back to roughly its original rate (Davis and Haltiwanger 2001). Wolfers (2003) finds that reducing unemployment volatility by half would be equivalent of reducing unemployment levels by 0.25%. Using his data would indicate a long-term increase in happiness among each member of the population of 0.003 per year. Unlike the other data in the happiness section, a reduction in unemployment volatility would benefit all people in every single year rather than being limited to a given time. However, as explained in Chapter 2, calculating a reduction in unemployment volatility is very challenging, so it is left out of the calculation. Like health care, its omission could underestimate the impact of unemployment calculated in this paper.

EFFECTS OF OTHER MACROECONOMIC VARIABLES ON SWB How GDP Loss Affects Happiness The connection between GDP loss and happiness seems quite obvious, for if a country is wealthier, its citizens should be happier and wealthier as well. However, in terms of an oil price shock, the GDP loss can be trickier to pinpoint. GDP usually moves higher and lower with income, but the change in oil prices that should impact ones income is already accounted for.26 Economists who have tried to measure the impact of GDP on SWB have tried to hold income constant by keeping people in the same income quartiles. Yet by doing so, small income movements that would be present in an oil shock could be interpreted in

26

However, the connection between income and GDP has been weak since the recession of 2001 as the median income stagnated even as the country grew wealthier.

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these economic studies as GDP impacts even though they are direct income losses from higher oil prices. GDP alone could still affect happiness during an oil shock. If GDP falls, some wages that otherwise would have risen may remain stagnant, or some may fall assuming that some wages are not sticky.27 The income change measured in the income section only counts the direct impact of higher oil prices on the budget, not additional income losses from a weaker economy. It is also possible that a fall in GDP causes a psychological fear effect about their own finances similar to the effect hypothesized for an increase in the unemployment rate but separate from it. Nevertheless, because this explanation for how GDP alone affects happiness requires relatively complicated logic, it is quite possible that the estimates in this paper overestimate the effects of GDP changes. The two sources on how GDP affects happiness come to relatively different conclusions. Welsch (2007) seems to find a relatively small impact in which an increase in GDP of 1% in the short-run and long-run only increase measured happiness by 0.013 and 0.004 points respectively. The relative values seem to correspond with the calculations of adaptation to income gains of about 2/3 (Di Tella et. al. 2006). However, looking at older data, Di Tella et. al. (2003) find that a change of 1% of GDP will increase happiness by about 0.025 points per individual. They also find an adaptation effect, but the difference between the a change in the level of GDP and a sudden change in GDP are quite similar.

Thus, it would be good to look at the impact of an oil shock on personal income, but studies have generally not focused on that metric.

27

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Because of the potential for double-counting direct income losses of an oil shock, the numbers for the U.S. in an oil price shock are likely toward the lower end of this range. Di Tella et. al. (2003) mentioned that the impact of income on happiness trends downward over time in their data set. Considering that Welsch (2007) used newer data, he might be showing this diminished impact at the present time. The U.S. may have an even weaker connection because much of the GDP gains in the last few decades have gone to a relatively small group of the wealthiest people in the country, and this effect accelerated in the past decade. However, neither of these studies directly analyzes the impact of an immediate GDP loss. If a GDP loss is analogous to an income loss, an immediate GDP loss should be five times worse than a long-term GDP gain. In other words, the effect Welsch (2007) found of 0.004 points for a 1% level change in GDP would be multiplied by five times to a change of 0.02 for an immediate GDP loss, which is very similar to the magnitude of the effect Di Tella et. al. (2003) found. For the purposes of this paper, 0.013 points will be assumed to be the effect of a loss of 1% of GDP, which is the effect of a change in Welsch (2007). Due to the wide uncertainty of the effect and how it relates to an oil price shock without double counting direct impacts on income, the sensitivity analysis will range from 0.002 to 0.025. This extremely large range is between half of the value Welsch (2007) measures and the value in Di Tella et. al. (2003). The upper range is also twice as large as the change impact Welsch (2007) measured. If GDP is analogous to income, a given loss should be twice as bad as an equivalent gain,

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and 0.025 is twice as bad as the change measured in Welsch (2007). The change he most likely measured was the impact of a GDP gain rather than a loss.

Inflation and Interest Rates Describing how higher inflation and interest rates negatively impact SWB is somewhat difficult, but various possibilities are plausible. For inflation, it could temporarily reduce real incomes if core inflation rises and incomes are set in nominal terms so they do not respond to increases in inflation.28 While this impact still likely is common, it probably has decreased in importance since the 1970s given the reduction in the percentage of workers who are in unions, especially in the private sector (Becker 2009). Unions often negotiate contracts for one or more years in advance, and some wages are set as nominal figures. At higher levels, inflation could lead to menu costs, or frequent price changes that might reduce happiness if consumers feel rushed when deciding whether to purchase goods (Gorodnichenko 2009). The negative costs of higher interest rates could come from making borrowing for consumers more costly, further reducing income. Yet according to the 2007 Survey of Consumer Finances, the vast majority of household debt is long-term or does not respond to higher interest rates (Bucks et. al. 2009). Even credit card rates are quite sticky. Additionally, an increase in interest rates may be a cause of lower GDP, raising the potential for double-counting negative effects on individuals. Still, a higher interest rate makes new purchases more

The income effect should pick up the direct impact of an oil shock on overall inflation because the basket of goods a consumer purchases, which includes fuel, becomes more costly.

28

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costly, especially for expensive durables like automobiles, limiting consumer options. The reduction in ability to make planned purchases could lead to a decline in happiness. A more complicated logic is that government borrowing costs would rise, which would necessitate higher taxes and reduce income. Such a possibility makes sense theoretically, but the Federal government has not shown much desire to balance budgets in this way. Temporary higher borrowing costs may have more of a long-run effect though higher taxes or higher interest rates to raise enough money to pay for the higher government debt. However, unless the increase in interest rates is very substantial, the effect on the Federal debt will be quite small, and the magnitude of this effect will shrink over time due to inflation. The quantitative estimates of the negative impacts of inflation are more developed than they are for interest rates. Various economists have tried to compare the impact of a change in inflation with a change in the unemployment rate, and they have found unemployment is significantly worse than inflation. While Di Tella et. al. (2001, 2003) find unemployment to be about twice as bad as inflation, Wolfers (2003) calculates that it is more than four times worse. An average of their estimates is -0.0075 points per percentage point change in inflation. This would be 3 times less than the effect of a 1% rise in the unemployment rate. In contrast, only Welsch (2007) has conducted an analysis of the SWB impacts of long-term interest rates. While he finds a very dramatic impact of changes in interest rates, his estimates seem unreasonably high. His finding that

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each member of the population could average 0.05 lower SWB when interest rates are 1% higher seems improbable but possible, but his finding that a quick change in interest rates of 1% could lead to nearly an average 0.40 point decline is ridiculous. This figure is the equivalent of every single person in a country becoming unemployed! Because of unreliability of impacts on interest rates, the calculation will be based off the impacts calculated for inflation. The -0.0075 finding will be the midpoint for the calculation, but there will be a wide range for the sensitivity analysis. The sensitivity analysis will range from -0.002 to -0.015. The low end represents the low calculation from Wolfers (2003). No source calculates as large of a decline as -0.015, but this figure can also take interest rates into account. Further analysis of the effect of interest rates short-term, long-term, and for durable goods and assets are needed before a more precise estimate will be possible. The impacts described here may overestimate the impact of a shock because income and GDP may already account for much of the effects from inflation and interest rates. However, using the impacts of only inflation to measure the impacts of both may make the estimate more accurate.

POTENTIAL NATIONAL SECURITY IMPACTS ON HAPPINESS As explained in Chapter 2, an oil price increase has an uncertain negative effect on actual national security. Yet the concerns and fears of citizens often do not match objective risks, and citizens often overestimate the probability of

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infrequent but potentially devastating events like a terrorist strike (Jenkin 2006; Slovic et. al. 2004). An oil price shock may cause some Americans to fear that the increased money flows to the Middle East and autocratic regimes in countries such as Venezuela and Russia pose a national security risk. Some may feel as though it could increase the risk of terrorism, and it is possible that those who are in the military or are close to those in the military may feel greater concern for their own safety or for the safety of a loved one. Both of these feelings could reduce self-reported well-being. Frey et. al. (2004) study the impact of terrorism in France and the United Kingdom using the Eurobarometer surveys. They find that terrorism has a significant impact on life satisfaction. A one-standard deviation change in the number of attacks in France (about 10 incident) or deaths in the UK (about 53/year) reduces average satisfaction by 0.029 and 0.041 points respectively, or about the effect of a 1-2 percentage point increase in the unemployment rate. However, this finding only shows that increased intensity or frequency of attacks lowers well-being, not risk factors for an attack. Additionally, the impact on life satisfaction appears to strongly depend upon a few particularly deadly years in France and Northern Ireland. Without these brief and intense periods, the impact on life satisfaction is either much smaller or insignificant. Risk of terrorism will be left out of the calculation because of the lack of evidence establishing a link between risk factors for terrorism and actual wellbeing decline. Some small impact is still possible, so the actual negative effect of an oil price shock on well-being might be larger than that calculated in this paper.

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BENEFITS OF AN OIL SHOCK Quantifying many of the benefits of an oil shock require philosophical reasoning into the value of a death, how to discount happiness, and how to properly account for climate change from the perspective of current U.S. residents.

Traffic Congestion Traffic congestion is a mental and physical burden with numerous private and social costs (Stutzer and Frey 2008). Koslowsky et. al. (1995) describe many problems associated with traffic congestion including higher blood pressure, musculoskeletal disorders, lowered frustration tolerance, increased anxiety/hostility, bad mood at work and home, absenteeism and turnover at work, and worse cognitive performance. Congestion also exacerbates air and noise pollution. Stutzer and Frey (2008) note that economic theory predicts that people should be equally happy regardless of the length of their commute to work. If people were perfectly rational agents with perfect information, the price of land or their wages would fully compensate them for driving. However, Stuzer and Frey find that individuals living farther away from their jobs are no more satisfied with their homes, less satisfied with their jobs, and report lower life satisfaction. They speculate that individuals do not realize the costs of commuting or overestimate their ability to adapt. Driving distances could also increase unexpectedly from the time when one first moves to a new residence.

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Using the GSEOP for 1984-2002, they find the happiness of each individual should fall by 0.0012 points on a four-point scale for every minute more their commute takes each way. The sensitivity analysis assumes values 50% lower and 50% higher, or 0.0006 and 0.0018. This value may be underestimated if a shorter commute improves productivity or the well-being of their spouses, friends and co-workers.

Reduced Fatalities from Traffic Accidents The value of life in terms of happiness is a deep philosophical question that should be debated. However, this paper will provide one way to measure a death. Happiness in this paper is measured on a scale from one to four. Death is assumed to be the equivalent of zero. Thus, if a person dies who would have lived one additional year was fairly satisfied with his life (a three out of four), the loss of happiness in that case would be three. An average death must be calculated for this paper. According to data from the National Highway Traffic Safety Administration (NHTSA), the median age of a person who dies in a traffic accident is about 37 (FARS 2008).29 The Social Security Administrations actuary table calculates that a 37-year-old man has an additional life expectancy of 40 years, while a woman of the same age has a life expectancy of about 44 years (SSA 2004). Considering that about two-

29

By the time people turn 35, 47.38% of all people who die in traffic accidents have died, and by the time they turn 45, 62.04% have died. Therefore, one would expect that each additional year from 35-44 will kill an extra 1.46% of the total. With these numbers, there would need to be an extra 1.78 years from age 35 and zero months, so the median death is probably about 36.8 years.

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thirds of those who die in traffic accidents are men, the average additional life expectancy of the median person dying in a traffic accident is about 41 years. Yet death also negatively impacts the happiness of loved ones. Lucas (2007) shows that widows have a precipitous drop in life satisfaction that is as significant as becoming unemployed. They only slowly recover, regaining about one-half of their loss of the initial year by the third year. However, his analysis may not be appropriate for widows (and widowers) who lose their spouse in an unexpected traffic accident. His analysis appears to mostly show the effect on widows whose spouses die after battling a long illness because the widows life satisfaction is in steady decline for years before the actual death. Also, it can be assumed that the happiness impacts may linger for decades. Going back to the individual, a simple calculation for the impact of a traffic death would multiply the expected years alive (41) by the average happiness during that time, 2.93 (Easterlin 2006).30 Thus, the happiness loss from each individual dying in a traffic accident would be close to 120. The additional happiness loss from the grief of loved ones would also have to be included. Using data from Lucas (2007), it appears as though a widow(er) loses about two points over the first eight years after the death of a spouse. Assuming a negative impact throughout life and negative impacts to other family members and friends could increase this figure to about 135.31
30

The average happiness in the U.S. is very close to 2.2 out of 3, which is 2.933 when translated to a four-point scale. 31 Estimating the effect on family and friends is quite inexact. If the widow is two points less happy in the first eight years, and there is already some adaptation, then the total impact over 40 years must be less than 10. The impact on parents will probably be roughly equal to the spouse for the first eight years, but they on average will not live much more than an additional decade. The children could also be less happy, potentially about equal to the widow. Thus, a widow(er),

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The Discount Rate of Happiness The happiness loss from a traffic accident occurs over so many years that it requires a discount rate of happiness. Unlike money, happiness cannot be as easily invested today for happiness tomorrow. However, people can still choose to increase their happiness now by a small amount (by smoking, drinking, foods high in saturated fat, etc.) but risk having a shorter life in the process. Similarly, traffic accidents also deal with risk for short-term gain. Every time somebody goes out and drives in order to achieve some immediate happiness, such as going to a grocery store to pick up food, they assume a risk of property damage, injury, or death from a traffic accident. Those who choose to drive recklessly could have greater immediate happiness, but they are also taking a greater risk. In a paper about valuing lives using a subjective well-being framework, Dolan et. al. (2008) mention that the range of discount rates for happiness is generally lower than it is for monetary transactions. They provide a range of 013% in terms of the discount rate of happiness. However, for someone driving, the discount rate should roughly be the probability of dying, which at age 37 is about 0.20% and 0.10% for men and women respectively (SSA 2004). Death rates do not hit 3%/year until age 71 (men) and 76 (women) and 6%/year until age 79 (men) and 83 (women).

two parents, and two kids should have a decline of happiness of about 10 points in the first eight years. Noting that the negative effect on an average widow is only of the magnitude in the eighth year as the first, there probably can be an additional negative effect of about five over any additional years after the eighth (Lucas 2007). Thus, the total used in this paper is 15.

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The probability of death increases about 9%/year for both men and women. Using just the death rates for men as a discount rate would result in a reduction of the happiness loss from 120 to 103.7. Women have a lower probability of death at every age, and discounting using their probability of death would result in a happiness loss of 108.9. Given that men are more likely to die in accidents, the happiness loss for each death will be assumed to be 105. As a comparison, using a discount rate of 3%/year would have a much more dramatic effect, reducing the happiness loss by over 40% down to about 71. One potential criticism of this way of valuing death is that it assumes the length of the life the person would have lived based upon current actuarial tables rather than the length of the life the person may have lived given medical advancements. For instance, living to be 100 a few decades from now could be commonplace, but this calculation only assumes the current lifespan in the U.S., which is around 80. The sensitivity analysis will have a midpoint of 120 with a low of 73 and a high of 135. The midpoint takes the discounting into account but also includes the effect of 15 on friends and family, which cancel each other out. The high estimate includes no discounting, and the low discounts at 3% per year and only includes the two points of SWB decline the spouse feels for eight years.

Improved Air Quality The emission of localized air pollutants such as particulate matter (PM) and various nitrous oxides (NO x) can reduce happiness by leading to a reduction

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in agricultural output, visual pollution in the form of haze, respiratory problems, and premature death (Krewski 2009). A happiness or life satisfaction survey should help identify the magnitude of most of the first three problems. Separate studies have analyzed how air pollutants reduce expected life span (e.g. Pope et. al. 2009) Unfortunately, the only paper attempting to analyze the effect of air pollution on life satisfaction uses a dubious metric for air pollution, and it is not used for this paper. Welsch (2002) compares life satisfaction across countries on the basis of the difference in nitrogen dioxide (NO2) pollution per urban resident.32 However, the only amount that matters for health is the ambient pollution level that individuals would breathe. Because each person breathes the same air, the amount of pollution per capita does not matter. Even with a credible methodology, such a survey may underestimate the effect because reduced agricultural output could lead to localized devastating agricultural losses and price increases for consumers. Also, having more patients who require more medical attention for their respiratory problems can lead to an increase in health insurance premiums, reducing the income of many Americans and the probability of having health insurance. The value of the deaths follows the same pattern accounting for traffic deaths. The effects are not discounted, discounted at the rate of probability of death, and discounted at 3%/year for the high, midpoint, and low estimates respectively.
32

Using the Eurobarometer from 1992 to 2002, he finds that for each 1 kiloton/capita in urban nitrogen dioxide pollution by 1 kiloton/capita results in 0.3% of the population falling one category (t-value 1.83). Thus result is only marginally significant with p-values of about 0.06.

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CLIMATE CHANGE Creative techniques are needed to try to assign a value in terms of happiness to the reduction in emissions of greenhouse gases (GHGs) resulting from reduced oil use. The rest of the impacts in this paper only focus on the wellbeing of current residents of the U.S., but GHGs emitted today will likely affect the lives of those not yet born, citizens of developing countries, and non-human species and ecosystems to a greater degree.33 While the climate change calculation is not included in this paper, it will become especially important when analyzing policies to reduce oil consumption.

Long-term Domestic Effects The effects of GHGs on individuals currently in the U.S. can be discounted in much the same way as death is discounted in this paper. The probability of death in any given year would be the discount rate of happiness. Some may argue that an appropriate discount rate would be somewhat higher for emissions of GHGs because it involves a conscious choice to invest in sources than emit fewer GHGs today with an expectation that emissions will in fact fall. This decision is quite similar to a traditional investment, which would normally be subject to a discount rate of 3-6%.34

Some could raise the concern that the happiness of illegal immigrants or those currently residing in the U.S. who are not citizens should not be counted the same as citizens of the country. This paper assumes that any person living in the U.S., regardless of immigration status, is counted equally, although from a political context, the happiness of voters and future voters (who of course must be citizens) will probably be weighed higher. 34 However, the traditional discount rate for investments might itself be overstated. If the goal of investing is to eventually achieve greater happiness, and there is diminishing marginal utility from greater income, the actual underlying discount rate of happiness should be less than the commonly measured figure. For instance, assume a person has $1,000 and has the opportunity to invest it in

33

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In contrast, most citizens likely do not approach a small reduction in driving as an action that can measurably decline their probability of dying in a traffic accident. A traffic death is a completely unexpected event, quite different than the very reasonable expectation that paying to reduce GHGs should result in lower emissions and hopefully diminished impacts from climate change. This difference in expectation and planning makes climate change more like an investment with its attendant discount rate range, while highly unlikely traffic deaths would have a discount rate closer to the risk of dying. Climate change also may more dramatically affect those currently not born, a problem known as intergenerational equity. One response is to ignore any difference between those currently alive and those who will be born, simply assigning a common discount rate to time. Such an approach is very straightforward, but the choice of this discount rate of happiness without thinking about how society treats future generations may be somewhat arbitrary. Another approach would look at current spending on children by parents and the government, primarily in the form of schooling but also including health care and other social services. Our society assumes that children and teenagers should do relatively little or no paid labor until they are at least 18, and most young Americans who go to college do not begin fully supporting themselves until they are in their 20s. Such a long period of dependency can be seen as an investment in a future generation using money that adults who are working could
some spectacular stock that will double in value in real terms in one year. From a traditional perspective, the discount rate for passing up the investment would be 100%. Yet if spending that second $1,000 can only achieve one-half the happiness of spending the first $1,000, an outcome in line with diminishing marginal utility, the actual discount rate of happiness would be 50%. It is the same as if the person only got a 50% return and could get the same utility from each dollar.

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have used on themselves. Understanding the ratio of money earned that goes to ones own well-being (generally in the form of current consumption for oneself or saving for retirement such as Social Security) to that spent on children can give a sense of the comparative importance of ones own happiness and the happiness of future generations. This approach could be used on its own or help influence a long-term discount rate for happiness. But before it could be used, it would need to overcome numerous and quite difficult conceptual hurdles. For example, does it make sense to view the amount of money spent as a ratio, or should the money spent and also free time lost be translated into a happiness loss equivalent? To what extent does it matter that individuals sometimes decide to take higher-paying jobs to support their children, or choose to work less in order to stay at home and care for their children? Despite these and other challenges, understanding how adults value children relative to themselves seems important for calculating an appropriate intergenerational or long-term discount rate for happiness.

Impacts on non-U.S. Residents Calculating the relative value of happiness for a non-U.S. resident compared with someone living in the U.S. can be very similar to the process for determining the value society places on future generations in the U.S. Individuals spend money on childrearing, and they also give to international charities. Similarly, governments spend money on education and give foreign aid directly to countries and international institutions such as the United Nations.

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Similarly (and unfortunately), the process for actually calculating the relative happiness presents many challenges. In terms of dollars for climate change, the U.S. would help lower-income countries, many of which would face difficulty trying to adapt to a changing climate. However, some foreign aid currently goes to countries such as Israel that have money to adapt to climate change. Also, whereas developed countries spend relatively similar amounts on childrearing and schooling, various countries spend very different percentages of their GDP on foreign aid. This demonstrates that the U.S.s observed spending to help foreigners might not be ethical or fair, and the actual value the U.S. should place on foreign lives and suffering should be different.

Impacts on Ecosystems and non-Human Species Once again, the amount Americans give to charities focusing on wildlife causes and what the Federal and other governments spend on wildlife conservation can be used as a proxy for the value of various species and ecosystems that climate change endangers. However, these species and various ecosystems can also have economic value in promoting eco-tourism and a health value as sources of compounds for new medicines. Both the economic and health values can be translated into expected SWB gains.

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OVERALL IMPACTS As in Chapter 2, this chapter ends with a quantitative overview. Table 3.2: Quantitative Estimates of SWB Impacts Effect Unit MidLower Upper point bound bound change in SWB (1-4 scale) Income change Per $1000 -0.058 N/A -0.081 st 1 quintile lost Income change Per $1000 -0.044 N/A -0.062 nd 2 quintile lost Income change Per $1000 -0.027 N/A N/A rd 3 quintile lost Income change Per $1000 -.0077 -.0046 N/A th 4 quintile lost Income change Per $1000 -.0036 -.0022 N/A 5th quintile lost Employment Per person -.45 -.30 -.60 per year Long-term Per person -0.91 -0.52 -1.82 employment Unemployment Per person -0.024 -0.1 -0.043 rate per 1% increase GDP Per person per 1% decline -0.013 -0.002 -0.025

Figures Possibly Underestimated or Overestimated?

Underestimated: health insurance

Inflation and Interest Rates

Per person per 1% increase Quicker Per person Commute per 1 minute decrease Reduced Traffic Per person Deaths Air Pollution Per year

-.0075

-0.002

-0.015

0.0012

0.0006

0.0018

Underestimated: health insurance; unemployment volatility Overestimated: some accounted for by income effect Overestimated: double-counting of income, GDP Underestimated: may improve productivity

120 2.56

73 1.72

135 2.93

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Chapter 4: How an Oil Shock Impacts Happiness Three out of four Americans . . . say that they already are very angry (40 percent) or somewhat angry (33 percent) about gasoline prices. - Reuters (June 2008) This chapter combines the effects of a unit oil price shock from Chapter 2 with SWB impacts of Chapter 3. The results indicate that a positive oil price shock has a strongly negative impact on happiness with negatives outweighing benefits by at least an order of magnitude. In this paper, the Utilitarianism-inspired unit of measure for changes in SWB will be called Utils. The Util relates directly to the Eurobarometer 1-4 scale. If one person in the U.S. becomes one category higher (lower) on the 1-4 scale for one year, the Util measurement of the country will increase (decrease) by one util. To give an example, if in a given year five people increase from fairly satisfied (3 out of 4) to very satisfied (4 out of 4) on the survey while two people fall from very satisfied to fairly satisfied, the country will have gained three Utils. This measurement can be subdivided by parts of the year or used to describe changes that last for more than one year, so a change of one category for one quarter is worth 0.25 Utils, and the same change for five years would be 5 Utils.

Number of U.S. Residents Affected and Trying to Account for Children Some variables such as income and the unemployment rate affect different numbers of people in the U.S. Also, it is unclear how to count the happiness of children. The surveys only asked about the well-being of adults, and it is

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uncertain if children respond in similar ways. While teenagers most likely respond in similar patterns to those aged 18-20 in the surveys, the effects become more uncertain or even unknowable the younger kids are. Considering that 24.5% of the U.S. population is under age 18 and 18.8% is under age 14, this uncertainty can affect results (Census 2008). Maximizing the happiness of children while they are children is somewhat philosophically complicated. It certainly is not as straightforward as the utilitarian hypothesis that maximizing the happiness of adults is ethically desirable, a concept that drives this paper. For instance, children who are strongly encouraged to do their homework and abstain from video games might report lower well-being, but they may do better in school and have more opportunities later on. Specifically for the calculation, all U.S. residents (300.3 million in 2007) including children are included for the effects of an oil price shock on income and air pollution (BLS 2008). The data for household size in regards to income do not differentiate between adults and children. The effects of air pollution are potentially more harmful to vulnerable people such as young children. In contrast, the effects on changes to macroeconomic variables (the unemployment rate, GDP, inflation, and the interest rate) are only counted for all adults (227.7 million in 2007), so it is possible those estimates are biased toward the low end (Census 2008). While it may seem strange that the employment rate could impact all adults and not just those working, the SWB surveys calculate the average response of all individuals, regardless of employment status. Calculations for

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those who commute to work and could get laid off only count those who are employed (146.1 million in June 2007), making these calculations the most narrowly focused (BLS 2007).

RESULTS Overall Results The results are presented in Table 4.1 for the negative impacts and 4.2 for the positive. The low estimate takes into account the low sensitivity analyses from both Chapter 2 and Chapter 3. A similar technique is used for the high estimate. This technique leads to extremely large ranges of possibility for GDP and inflation/interest rates, which had relatively uncertain effects for both impacts and effects on SWB. The high estimate of the impact of GDP on happiness is 50 times greater than the low estimate, while inflation/interest rates has an uncertainty of over 100-fold. However, these ranges likely overstate the actual uncertainty because the actual impacts are probably rarely at the far negative or far positive end for both economic impacts and SWB.

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Table 4.1: Negative Impacts of Oil Shock by Particular Effect Effects Midpoint of Low Estimate of High Estimate of Overall Impact in Overall Impact in Overall Impact in 1000s of Utils 1000s of Utils 1000s of Utils (of total midpoint (of total midpoint (of total midpoint negative impact) negative impact) negative impact) Income -2,492 (21.9%) -1,869 (16.4%) -3,115 (27.3%) Short-term Employment -598 (5.3%) -199 (1.8%) -1,197 (10.5%) Long-term employment -997 (8.8%) -285 (2.5%) -2,991 (26.3%) Unemployment rate -4,973 (43.6%) -1,036 (9.1%) -13,365 (117.3%) GDP -1,480 (13.0%) -114 (1.0%) -5,693 (50.0%) Inflation and Interest Rates -854 (7.5%) -46 (0.4%) -4,782 (42.0%) SUBTOTAL -3,549 (31%) -31142 (273%) NEGATIVE -11,395 (100%)

Population-wide Unemployment Impacts Seem Quite Large Nearly half of the negative impact in the scenario is a result of populationwide declines in happiness associated higher unemployment. The vast majority of these people will keep their jobs throughout the period, so it is possible that the fear of unemployment is the largest negative effect (Di Tella et. al. 2001). There is a possibility that this population-wide impact is somewhat overstated because the negative impact on employment may not be as high as 0.5% for a $20/barrel increase, and the midpoint chosen for the impacts to SWB was toward the high end of the range of sources. But even if these figures were both at the low end of the range, they would still be about twice the magnitude of the positive impact from a shock as shown in Table 4.2. Much of oil shock literature has focused on the impacts to growth, and this result demonstrates a need to pay more attention to employment. Although it has

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been mentioned in a variety of paper, only a couple have specifically dealt with employment, and none has been released since 2002. Similarly, it would be good to better understand the mechanisms for population-wide unemployment unhappiness to find out the extent to which the assumption of fear or anxiety is the cause. Preemptively, government policies could look more closely at targeting employment or possibly perceptions of unemployment.

The Impact of an Oil Shock Is Almost Certainly Negative Table 4.2 shows that the positive impacts are much smaller than the negatives. The positive gain of 261,000 Utils only offsets about two percent of the loss of over 11 million shown in Table 4.1. An order-of-magnitude difference still remains when using the low estimate for the negative impacts and the high estimate for the positive estimates.

Table 4.2: Positive Impacts of Oil Shock by Particular Effect Effects Midpoint of Low Estimate of High Estimate of Overall Impact Overall Impact in Overall Impact in in 1000s of Utils 1000s of Utils 1000s of Utils Quicker Commute 48 9 131 Reduced Traffic Deaths 109 40 166 Air Pollution 104 40 142 SUBTOTAL POSITIVE 248 90 440 Note: Some totals do not add precisely due to rounding It is quite difficult to envision a scenario in which the positive impacts outweigh the negatives. Even if there are few macroeconomic changes, the income effect remains and at least accounts for about 16% of the overall negative

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impact, four times more than the high estimate from the positive outcomes. Some positives are overlooked in this analysis such as a reduction in injuries and property damage, but these omissions would need to be extremely large and overwhelm the other positive outcomes. Actual health-related impacts stemming from reduced health insurance and stress during an oil shock are larger in magnitude, and these could only be partially accounted for in the high sensitivity analyses of unemployment impacts.

The Income Loss From an Oil Shock Hurts the Middle Class the Most Table 4.3 shows a specific aspect of the calculation in terms of the impact of the income loss by quintile. Somewhat surprisingly, it hurts quintiles two and three the most, although quintile one is not far behind. Thus, an oil shock is a middle-class problem to a significant extent. One reason those in quintile one appear to be less affected is that likely only 65% of households in quintile one own vehicles (Cooper 2005). Particular individuals in quintile one may be very hard hit, although on average they do not suffer anymore than the others.

Table 4.3: Income Effects on SWB by Quintile Quintile Number Percent of Percent of Affected Overall Effect Overall (Millions) Population 1 40.86 19.1 13.6 2 52.88 31.5 17.6 3 60.09 29.5 20 4 69.70 12.1 23.2 5 76.91 7.8 25.6

Impact Per Person (1 = average) 1.41 1.79 1.47 0.52 0.30

The income effect still shows a very large gap between the bottom 60% of households and the top 40%. The top 40% of households have about 49% of the

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population household sizes grow in each quintile but the individuals only feel less than 20% of the impact. The sensitivity analysis (not shown) in which quintiles one and two have a risk aversion ratio of 7:1 while those in four and five only have a 3:1 ratio between the impact of a short-term loss and a long-term gain further accentuates this difference. Then the top 49% of the population only feel about 10% of the effect.

UNCERTAIN OIL SHOCK DURATION AND MAGNITUDE The analysis above assumes that the price of oil will go up suddenly, stay at its elevated level for one year, and then fall back to its pre-shock levels. This assumption is done for modeling purposes and does not actually reflect any previous shock. Shocks can be of different durations and magnitudes.

Duration of Oil Price Shock To provide some perspective, it can be helpful to think of a much shorter shock of one quarter and a longer one of a time period more like four years. The former is similar to the shock of 1990, while the longer shock is similar to what happened starting in 1973. As the oil shock lengthens, the impact on income declines every year due to adaptation, 40% after the first year and about twothirds by the fourth (Di Tella et. al. 2006). The effects of the positive externalities should stay relatively constant excluding a discount rate, although traffic deaths per 100 million miles traveled and air pollution from vehicles have steadily declined throughout time (FARS 2008; EPA 2008).

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The effect on the macroeconomic variables over time is less certain. Of the three possible mechanisms consumer behavior, supply shock, and external balances it seems as though only the external balances could have a long-term effect. Consumers and producers would respond to the initial price shock, but they would eventually adapt their basket of goods and investment decisions to the higher oil price. In this example, there is no price volatility other than the initial positive shock, so the effect of uncertainty on purchasing and investment decisions should become smaller over time. Overall GDP may be lower than it would have been at the same time in the absence of a shock, but the year-overyear growth rate should be similar, so the only GDP impact on SWB would be a reduction in income rather than leading to additional concern of declining economic conditions. In contrast, the impacts of having an elevated trade deficit may change during a longer period. While much of the impact would be constant over the period, interest rates could rise if lenders to the United States begin to question the sustainability of the long-term trade deficit and/or oil exporters in the Middle East diversify their portfolio away from treasury securities. A higher trade deficit could also impact the dollar, with subsequent effects on exports and likely other macroeconomic variables. However, both the magnitude and sometimes the direction of these effects are uncertain.

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Magnitude of Oil Price Shock A first-order approximation is that the impact on happiness of a larger oil price shock is proportional to that of a unit shock. If this were true, a two-unit oil price shock would reduce happiness by twice the amount of a one-unit shock. This assumption may not be valid, although it is unclear if the effect on happiness is more than proportional to the level of the shock or less so. Wolfers (2003) argues that the impacts on happiness become progressively worse as the unemployment rate rises, which would indicate that the effect on happiness is more than proportional. However, according to Prospect Theory, people respond more negatively to initial income losses than additional ones (Tversky and Kahneman 1992). In other words, happiness loss of the first positive unit oil shock would be greater than the loss of the second. Prospect Theory suggests the effect on happiness may be less than proportional.

POTENTIAL ARGUMENTS QUESTIONING IMPORTANCE OF SHOCKS The Impact on Happiness of a Price Decline This paper is concerned with a positive oil shock, but if the effects of a negative shock are perfectly symmetrical in terms of happiness and occur with the same frequency, concern about positive shocks in particular would not be warranted. However, some asymmetry is likely with both the macroeconomic effects and the effects on SWB, making a focus on positive shocks useful.

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Substantial negative shocks do appear to occur relatively frequently. Very dramatic declines occurred in 1986 and most recently in late 2008. Smaller declines or small shocks occurred in 1998 near the time of the Asian financial crisis, and the most recent run-up saw two short-lived price declines of about $20/barrel in 2001 and late 2006/early 2007. While the frequency may be quite similar, some asymmetry is likely with an oil price shock. Most analyses have found oil shocks to be strongly asymmetric with much larger negative impacts during rapid rises than gains during price declines (Hamilton 2008a). They argue that the major negative price shock in 1986 failed to produce significant gains for the economy. Additionally, part of the negative impact comes from the inability of manufacturers and business to adapt to changing consumer preferences. Consumer preferences can change just as much during a negative oil shock as a positive one, but the negative short-term impact of adjustment would counteract some of the benefits of a negative shock. Edelstein and Kilian (2007) contradict this claim, arguing that an assumption of symmetry is appropriate. They believe that the economy would have struggled in the absence of the 1986 negative shock. Investment that appeared to remain flat would have declined otherwise. They point to the Tax Act of 1986 (TRA86), which very dramatically eliminated tax incentives for many specific actions. They do, however, recognize potential mechanisms for how asymmetry could occur, and the point estimates in their model are quite asymmetric. Given how much of a change TRA86 was, they have a reasonable

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argument to look at historical specificity, but some of their claims in support of symmetry seem questionable. Concerning consumer behavior with automobiles, they say a consumer is just as likely to purchase a fuel-sipper following a positive price shock as a gas-guzzler after a negative shock. Yet consumers have less disposable income during a positive shock, and a positive shock can lead to higher interest rates, making the purchase more expensive. Even if the effects were perfectly symmetrical, the effect on SWB would still be asymmetrical with a positive shock being worse because a given income loss is worse than an equivalent gain. This effect is less clear for the macroeconomic variables, but there is no indication that a given gain for a variable like GDP is comparatively better than that GDP loss. Thus, a given loss is worse than a given gain, if only due to the income effect. Despite this near certainty that a positive oil shock has a negative impact, a subsequent price decline should offset some of it. A low estimate would be around 5%. This estimate combines the finding of Davis and Haltiwanger (2001) that a positive shock is ten times worse than a negative one with the finding that a given income loss is twice as bad as a given gain. In contrast, a high estimate could be over 50% assuming that the economic effects are only somewhat asymmetrical and macroeconomic variables have small or no asymmetries in regards to SWB.

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A Demand-Driven Shock May Have Less Impact Some of the impacts may vary depending upon the origin of the shock. The impacts described have generally been in response to a supply shock with a rapid reduction in supply. Yet some have argued that the impacts will be different for shocks that are due to demand growth. Some say that the macroeconomic impacts may be less prominent in these demand-side shocks because the shocks themselves generally occur less suddenly, and the economy is already growing rapidly, causing the increase in demand (Kilian 2008; Bebee and Hunt 2008). For instance, the rapid growth in China that likely contributed to at least some of the price increase over the 2002-2008 period probably benefitted U.S. growth (Hamilton 2008b). The data are not available to fully analyze this claim. It is still possible that a demand-side shock reduces growth and affects macroeconomic indicators, but the effects are less perceptible because the economy would be growing so rapidly in the absence of a shock. Future comparisons between the faster-growing 1990s with low oil prices and the slower-growing most recent decade with higher oil prices may indicate whether this hypothesis has merit. Even if the impact on macroeconomic variables is less pronounced, overall well-being may not be better from a demand-side shock. Even though U.S. GDP grew, median incomes stayed stagnant throughout the decade (Mishel and Bernstein 2007). Additionally, if macroeconomic variables are not impacted, oil demand can continue to rise, putting additional upward pressure on the price of oil. However, given the importance of the unemployment rate in determining

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happiness, and a growing economy tends to have a stable unemployment rate, there is a reasonable chance that a demand-driven oil shock is better than a supply shock on average.

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Chapter 5: Maximizing Happiness in the Next Positive Oil Price Shock The greatest happiness of the greatest number is the foundation of morals and legislation. - Jeremy Bentham, Commonplace Book in Works, Vol. X As explained in Chapter 4, the happiness decline associated with a positive oil price shock strongly outweighs the benefits. This finding creates a strong rationale to find ways to reduce the negative impact on happiness of future oil price shocks, particularly through government policies. This chapter will describe potential policies that would directly address particular damaging components of an oil price shock that the analyses in Chapters 2 and 4 demonstrated. To recap these issues, oil shocks cause an income effect, and the impact on consumers and firms budgets lead to changes in purchasing behavior. These purchasing behavior changes can hurt macroeconomic variables when manufacturers and businesses are unable to quickly respond. Policies can also try to address unemployment, which appears to be a large component of the negative impact of a shock. Finally, a larger trade deficit can be risky.

USING SWB CALCULATIONS TO MAKE POLICY Marginal Costs and Benefits The previous calculations in this paper dealt with total costs of all U.S. oil consumption. In order to analyze policy, those total costs must be translated into marginal costs. For instance, a given reduction in gasoline consumption is expected to reduce the impact of a price shock on household budgets on the margin, but a significant impact will remain. This improvement in the happiness

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of consumers during an oil price shock is the marginal benefit, while the cost of implementing the policy is the marginal cost. Such an approach is a direct application of basic economics. In most cases, the happiness benefit is probably proportional to the percentage reduction in consumption. For instance, it was calculated in the previous chapter that the total cost of a one-year-long unit shock is about -11 million Utils. If consumption falls by 1%, it would be assumed that the cost of the shock would fall by 1%, or 110,000 Utils. However, such an association does not always hold true, especially if the consumption reductions occur among wealthier individuals who are able to purchase more efficient vehicles. Any benefits need to be discounted because they would occur in the future.

Judgment is Necessary Deciding on a particular set of policies requires a great deal of judgment because of the large uncertainty of deciding on the magnitude, timing, and frequency of future oil price shocks. Policy options should be proportional to the risk one is willing to take. For instance, assume a policymaker is concerned about a one-year-long unit shock 10 years from now and does not think there will ever be another shock. Policies should be implemented that can reduce consumption 10 years from now by 1% so long as their discounted cost is less than 110,000 Utils. Yet if a different policymaker were concerned about two three-unit shocks of the same duration, an acceptable cost for a 1% consumption reduction would be closer to 660,000 Utils.

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Addressing Issues Related to a Shock with Policy Policies can attempt to reduce the SWB decline related to income loss, the impact on the budgets of consumers and firms, and the inability of manufacturers to quickly respond to changing consumer preferences. Addressing unemployment related to oil shocks is of particular concern, as are potential risks from a higher trade deficit. Policies to address the happiness effect associated with income and the impact on budgets are quite similar, although higher-income individuals who do not feel much direct impact of an oil shock can still change their purchasing preferences in a way that hurts the macroeconomy. Reducing the effects on income and budgets can both be achieved by reducing the quantity of fuel consumed, which can come from a fuel economy standard, rebate or tax on the purchase of vehicles depending upon the efficiency of the vehicle, a program to buy inefficient older vehicles, or a tax on gasoline. It is also possible to quickly change the cost of fuel by reducing taxes on it or trying to blunt the effects of the high prices by giving cash transfers to certain households. In contrast, the government would need to try various firm-specific incentives or mandates to try to ensure that manufacturers can quickly adapt to changing conditions.

How Consumers Purchase Vehicles A model of how consumers purchase vehicles makes the impact of various policies easier to understand. One reasonable model assumes that consumers assign a constant value to many attributes of a particular vehicle (size, power,

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comfort, reliability, safety, how it makes them feel, how it could improve their social position or opportunities, etc.).35 They then subtract the variable expected cost of gasoline that depends on the cost of gasoline. This cost for gasoline is probably estimated for about three years (Greene et. al. 2002). Consumers then compare this total value (value of attributes minus the cost of gasoline) with the actual price of the vehicle, and they choose the vehicle that gives them the greatest benefit, also known as consumer surplus. In many cases, the price of gasoline that consumers use is probably the current price for gasoline assumed to be constant for three years in the future. However, during and soon after an oil price shock, it is difficult to know what value consumers will use in their decisions. Also, intangible attributes that are quite prominent with vehicles such as how the vehicle impacts their social standing and relationships could also be sensitive to the price of gasoline. For instance, buying a HUMMER in mid-2008 with gasoline prices at about $4/gallon could have been seen as ostentatious. Using the simple model of vehicle purchasing behavior, a consumer may have both calculated a lower intrinsic value for the HUMMER and the higher cost for gasoline. This example leads to the hypothesis that an oil price shock can impact vehicle purchasing behavior to a greater degree than the change in price of the gasoline would indicate.

Many of these attributes could also be considered costs. For instance, there is an expected value of future maintenance. For this paper, it is easier to group all other attributes as positives and only the gasoline price as a negative. Also, some consumers will look at the price of diesel rather than gasoline for their vehicles, although diesel has relatively low penetration in the U.S.

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POLICY OPTIONS This section discusses policies that address the mechanisms leading to SWB loss including impacts on consumer budgets and inflexibility of manufacturers. The risks of a trade deficit can be addressed with increased supplies in addition to decreased oil demand.

Fuel economy standard The major policy to reduce gasoline consumption in the U.S. since 1975 has been the Corporate Average Fuel Economy (CAFE) standard. The 2007 Energy Independence and Security Act of 2007 (EISA) mandates that the average sales-weighted fuel economy of new vehicles in 2020 must be 35 mpg (H.R. 6 2007). Raising the standard more would lead to an additional reduction in future gasoline consumption. Although people do drive slightly more in a more efficient vehicle, this rebound effect is quite small, with a short-term effect of less than 5% and a long-term effect of at most 20% (Small and Van Dender 2007). However, it takes a long time for the policy to have its full impact. The median vehicle is on the road for 17 years, so the fuel economy standard from EISA will not have its full impact until the mid-2030s, although this effect is partially offset because new vehicles are driven more (EERE 2008). Additionally, the CAFE standard primarily insulates the well-off from the effects of an oil price shock at first. The median household income of a new vehicle buyer is $82,342, compared to the median income for all households of about $45,000 (Wards 2008; BLS 2008). Wealthier households are also more price elastic in response to

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gasoline price changes, so they have less of a need to reduce or change their spending elsewhere in the economy (Hughes et. al. 2008). Thus, they are probably less responsible for the change in consumer preferences that hurt macroeconomic variables.

Feebate or Its Components (Fee or Rebate) A feebate is a combination of a fee on inefficient new vehicles and a rebate on those that are efficient. Feebates have been proposed in various U.S. states, and they can be made revenue-neutral (Langer 2005). It is also possible to implement either half, although it has been much more politically feasible to use rebates rather than taxes. A feebate should generally have the same effect of a fuel economy standard in terms of boosting the efficiency of new vehicles sold. However, its effects are somewhat less predictable because auto manufacturers can change the price of new vehicles, partially or fully offsetting the effect of the feebate, at least initially. For instance, from 2002 to 2005, the price of large SUVs fell $2,300 relative to small cars as gasoline prices rose about $.75/gallon (McManus 2007). If this problem can be overcome, or if the feebate is so substantial that auto manufacturers cannot fully offset prices of efficient or inefficient vehicles, a given feebate should have a relatively large impact because consumers appear to be myopic and only consider about the first three years of fuel costs (Greene et. al. 2002). Fuel costs are a smaller component of the overall purchasing decision, so a rebate or tax based on fuel economy is comparatively larger.

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A feebate should also initially work faster than a fuel economy standard because a feebate causes relative sales of current-model vehicles to change rather than needing to wait for the next generation of vehicles with a fuel economy standard. A quicker reduction in gasoline consumption means that the U.S. would be less vulnerable to oil price shocks that occur before the 2030s. Another variation of a feebate that targets used vehicles may also address the concern that a fuel economy standard does not at all quickly help those of lesser means. Yet this effect is uncertain because the price change from dealerships may offset the rebate on certain used vehicles. Feebates also have the potential long-term benefit of incentivizing the development and introduction of very efficient vehicles. A rebate can also be instituted for particular technologies such as plug-in hybrids in order to have them get a foothold in the market. In contrast, an auto manufacturer will not get much CAFE benefit for a small production run of a highly efficient vehicle unless the law is specifically designed to account for it. A simple feebate would only focus on oil consumption, in effect strongly incentivizing transformational technologies such as plug-in hybrids or all electric vehicles that could sharply reduce (or even potentially eliminate) the need to import oil. Feebates do have the problem that the efficiency of new vehicles is still strongly determined by the current price of gasoline. Unless the feebate is designed to vary inversely with the price of gasoline, vehicle efficiency will likely drop during periods of low prices, potentially leading to a more significant negative impact later on during a future oil price shock.

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Cash for Clunkers This policy rewards consumers for disposing of inefficient vehicles and buying more efficient vehicles. Currently it is being implemented in Germany, and a bill has been introduced in Congress (Bedard 2009). Part of this plan is similar to the rebate component of the feebate, and it should reduce gasoline consumption. Unlike a rebate, it tries to directly target those who potentially own older vehicles of lesser value who are more likely to be less wealthy. The policy is unsustainable for any long period of time. It is quite expensive and inefficient to constantly try to take certain vehicles off of the road. A cash for clunkers plan is probably best used during an oil price shock to provide relief to those with older, inefficient vehicles and to bolster potentially declining sales for new vehicles. While it is unclear how many people who own these vehicles would actually purchase new vehicles, a cash for clunkers plan can also be developed to reward purchases of efficient used vehicles.

Gasoline Tax Many economists prefer the idea of taxing gasoline over other regulatory options because it reduces vehicle miles traveled in addition to increasing the efficiency of vehicles. Like a feebate, it increases the efficiency of new vehicles by changing prices. However, it also directly increases the desirability of efficient used vehicles, and a feebate would need to be more comprehensive to cover used vehicle purchases in order to do the same.

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A gasoline tax may make new vehicle purchases more consistent during a shock, which is beneficial because it reduces the macroeconomic impact of inflexible manufacturers who cannot quickly change to consumer demand. With a gasoline tax, if the price of gasoline is consistently high, a price shock will result in a smaller percentage change in its price. For all other goods, a smaller percentage change should not directly lead to reduced changes in purchasing behavior because the absolute magnitude of the impact on ones budget is the same. But for new vehicle purchases, consumer preferences are likely to stay more constant with fuel costs that change by a smaller percentage.36 However, due to consumer myopia, the tax itself may have a relatively small impact. The effect is the reverse of the benefit for the feebate. Since myopic consumers underestimate gasoline costs when purchasing a vehicle, additional gasoline costs in the form of a tax will continue to be underestimated. Additionally, the happiness metric used in this paper suggests that it may be difficult to implement a tax. As Tversky and Kahneman (1992) show, a given monetary loss is twice as bad as a given gain. In order to overcome this problem, the benefits of the policy will need to be quite large, and/or much of the tax revenue will need to be recycled back to consumers. Yet a general scheme for recycling tax revenue would reduce well-being because roughly equal numbers of people would benefit and lose out, but the happiness of the latter group would fall by twice the amount of the gain of the former. A progressive redistribution

In absolute terms, having a tax makes no difference. But the assumption is that a consumer will respond more in terms of new vehicle purchases when gasoline prices change from $2 to $2.50/gallon compared with $4 to $4.50/gallon is plausible since the percentage change is so much larger in the first scenario.

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should result in better effects on happiness because of the declining marginal utility of income. Finally, although a gasoline tax sounds straightforward, it is unclear what fuels would be taxed at what levels. Diesel would likely be taxed, but ethanol from various feedstocks or domestically-produced fuels such as oil shale might be taxed at different rates depending upon political pressures.

The Gas Tax Holiday One way to try to reduce the impact of a shock is to try to counteract the price so no shock ever registers. The government could reduce the tax on gasoline as the price of gasoline rises, in much the same way as Senators McCain and Clinton proposed during the 2008 campaign. Such a plan would potentially work better if the gasoline tax were higher; currently the Federal tax is 18.4 cents/gallon (EIA 2008). Numerous problems plague this idea. It can be very expensive, it is not targeted, and economists note that with the short-term inelasticity of gasoline supply, the tax cut would not go to consumers at first (Krugman 2008).

Cash Transfers This policy would send checks to particular households during an oil shock, probably some in incomes quintiles one and two. It is a much more targeted version of the gas tax holiday that does not run into problems related to relative elasticities. The benefits of this kind of policy would need to be

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compared with the opportunities costs of spending in this way or running a higher deficit.

Flexible Automobile Manufacturing Manufacturers have moved toward flexible manufacturing in which they can change along with consumer demands (IHS 2005). Such a move should reduce the frictions that cause unemployment and other macroeconomic variable changes. Government may have a role in encouraging, incentivizing, or mandating automotive firms to become more flexible. Other businesses may also be targeted if it is found that companies are not flexible enough because they are not taking into account the cost of future layoffs to their employees.

Increasing Domestic Supply An increase in domestic supply should reduce some of the negative risk large interest rate increases possible with a large trade deficit. However, even if the trade deficit does not increase as much in a future shock, foreign lenders can still significantly impact the U.S. economy by buying U.S. treasuries with money coming from oil importers outside of the U.S. In addition to demand reduction policies described above, an increase in domestic supplies will reduce the trade deficit in a future shock, although the effects are likely to be relatively minimal, at least from conventional oil. Some alternative sources such as natural gas and electricity may have their own problems with price shocks. As shown with corn ethanol, agricultural prices are

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also subject to price shocks that can hurt the budgets of consumers. Unconventional sources such as tar sands have greater carbon emissions (Kockleman et. al. 2008). Thus, while some alternatives may be beneficial, an analysis looking at their overall impact on well-being is needed before policies are implemented to directly incentivize any of them.

CONCLUSION/FUTURE RESEARCH These policies can be combined to maximize well-being. For instance, a possible ideal set of policies would include a feebate to encourage immediate changes in vehicle purchases, a fuel economy standard to make sure fuel economy continues to increase even if oil prices fall, and a plan to give some cash transfers to families in the lowest three income quintiles should another shock occur before vehicle efficiencies can be increased. A next step involves deciding upon the magnitude and duration of future oil shocks whose impacts should be minimized. Also, discovering the costs of these policies at different magnitudes is necessary for a life-satisfaction costbenefit analysis to be fully conducted. This paper needs to be updated as new research comes out about the impacts of oil to the economy and how various situations affect the happiness of individuals. This paper hopefully can be used to move discussions about oil shocks toward impacts on individuals. Broad, easy-to-measure goals such as energy independence, more plug-in hybrids, or greater economic growth may be correlated with well-being or with the wrong polices, they may not be. Over

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time, perhaps measures of SWB will become a cornerstone of policy analysis. Although they have their uncertainties, at least they can provide a glimpse at how various situations impact the lives of individuals in a way traditional economic measurements cannot.

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Appendix A: Data on Impacts of an Oil Shock

Employment Source Values Davis and Peak response after four quarters Haltiwanger (40% of entire response) p. 488 2001 Reallocation Quarters 3, 7, 11, 15 for unit rise: 0.44, 2.48, 3.14, 3.20% Reallocation 3, 7, 11, 15 for unit fall: -0.24, -0.85, -1.45, -1.81% Employment 3, 7, 11, 15 for unit rise: net -0.23, -2.19, -1.08, -0.49% Employment 3, 7, 11, 15 for unit fall: -0.40, 0.18, 0.55, 0.39 When include 1989-1993: only 70% of numbers above - When increase from $30 to $40 (33%), unemployment up 0.1% in year one and 0.2% in year two (for elasticity of 0.003 and 0.006) - With oil price shock, elasticities of 0.009 and 0.02 in years one and two

Data Source US manufacturing labor data 1972-1988, 4-digit SIC - Then extend period to 1993

AEO 2006

Global Insight, Inc. and Federal Reserve

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GDP Source AEO 2006

Values When increase from $30 to $40 (33%), change in year one and two: -0.3 & -0.6 (GI); -0.2 and -0.4 (FED); -0.2 and -0.5 (E& SR) When decrease from $40 to $30, impacts 1/5 the size Elasticities in year one and two: -0.011 and -0.021 Elasticities from oil price shock: -0.024 and -0.050 All elasticitites: - Mork et. al. (1994): -0.054 - Hamilton and Herrera (2001) over 42 months: -0.055 - Bernanke, Gertler, and Watson (1997): -0.027 if Fed Funds rate constant Hamilton (2003): -0.116 (NOPI) and -0.053 (LNR) Elasticity of -0.055 at maximum impact about five quarters later, and -0.14 as permanent reduction Change in U.S. GDP in recessions following oil crisis: -2.5% (56), -3.2% (73), -0.6% (78), -0.5% (80), and -0.1% (90) In response to 1990 oil price shock in quarters 1, 4, and 12: -0.60, -0.48, -0.61% (w/o monetary response: -0.63, -0.34, -0.54%)

Data Source Global Insight, Inc. (GI), the Federal Reserve (FED), and National Institute of Economic and Social Research (E&SR)

Jones, Leiby, and Paik 2004

- Hamilton and Herrerra (2001) and Bernanke, Gertler, and Watson (1997) both use the oneyear NOPI measure of oil price shock

Sill 2007

Increase in net price of oil; real GDP, quarterly data from 1948:4 to 2005:4

Hamilton 2008a

Cologni and Manera 2008

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Inflation Source Values Cologni and In response to 1990 oil price Manera 2008 shock in quarters 1, 4, and 12: 0.60, 0.77, 0.81% (w/o monetary response: 0.56, 0.63, 0.53% Chen 2009 Short-run elasticity before 1981Q3 0.0043, after 0.0028 Long-run: 0.169 - When increase from $30 to $40 (33%), change in GDP price deflator in year one and two: 0.2 & 0.5 (GI); 0.5 and 0.3 (FED); 0.3 and 0.5 (E& SR) - Elasticities in year one and two: 0.007 and 0.017 - Elasticities from oil price shock: 0.019 and 0.034 Figure 9 From Kilian: Elasticity of -0.075 - Claims statistically insignificant

Data Source

AEO 2006

Macroeconomic model; data from Global Insight, Inc. (GI), the Federal Reserve (FED), and National Institute of Economic and Social Research (E&SR)

Gronwald 2008 Sill 2007

Interest Rates Source Values Cologni and In response to 1990 oil price shock in quarters 1, 4, and 12: Manera 2008 0.65, 0.13, and 0.10% Gronwald 2008 Figures 7 and 8: Treasury Bill Rate Huang, Hwang, Figure 3 and Peng 2005

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Appendix B: Subjective Well-being Data

Income Source Di Tella, MacCulloch, and Oswald 2003

Values Income quartiles Europe life satisfaction: 0.143 (SE 0.011), 0.259 (SE 0.013), 0.397 (SE 0.017) Income quartiles Europe happiness: 0.131 (SE 0.014), 0.259 (SE 0.017), 0.378 (SE 0.019)

Data Source - Eurobarometer 1975-1992 (1-4, life satisfaction) - Eurobarometer 1975-1986 (1-3, happiness) - USGSS 1972-1994 (1-3, happiness) Eurobarometer 19751991(1-4, life satisfaction)

Income quartiles US: 0.161 (SE 0.022), 0.279 (SE 0.023), 0.398 (SE 0.025) Di Tella, Income quartiles: 0.12 (SE 0.004), MacCulloch, 0.20 (SE 0.004), 0.30 (SE 0.005) and Oswald 2001

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Employment Source Lucas et. al. 2004

Di Tella, MacCulloch, and Oswald 2003

Values Becoming unemployed: -0.35 (SE 0.05), -0.83 (SE 0.05), 0.34 (SE 0.04) [-0.13, -0.30, and -0.12 on 4-point scale] Being unemployed Europe (life satisfaction): -0.505 (SE 0.020) Being unemployed Europe (happiness): -0.39 (SE 0.023) [-0.52 on 4-point scale] Being unemployed US: -0.379 (SE 0.041) [-0.505 on 4-point scale] Level in Europe: -1.91 (SE .664) - Level: down by 0.035 SDs (SE 0.005) [1.2% of population falls one category] -Volatility: .25

Data Source GSOEP 1984-1998 (0-10, life satisfaction) Eurobarometer 19751992 (1-4, life satisfaction) Eurobarometer 19751986 (1-3, happiness) USGSS 1972-1994 (1-3, happiness)

Wolfers 2003

Eurobarometer 19731998 (1-4, life satisfaction)

Welsch 2007

Level: -0.043 (t-stat 6.14) Change: -0.043 (t-stat 2.05) Being unemployed: -0.33 (SE .007) Level: -2.8 (SE 0.6) Change: -1.0 (SE 0.9)

Di Tella, MacCulloch, and Oswald 2001

Eurobarometer 19922002 (1-4, life satisfaction) Eurobarometer 19751991(1-4, life satisfaction)

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GDP Source Di Tella, MacCulloch, and Oswald 2003

Values Level: 1.094 (SE 0.335) Change: 0.953 (SE 0.719)

Welsch 2007

Level: 0.004 (t-stat 2.00) Change: 0.013 (t-stat 4.33)

Interpretation Level (Change): 10.9% (9.5%) of the population increases one category with a $1,000 (1985$) which is $2,000 in 2008$ increase in GDP per capita and GDP/capita in 2008 is about $47,000/person; this is a 4.25% increase in GDP so per percent, it is about 2.5% (0.025) Level (Change): 0.4% (1.3%) of population increases one category with 1 point increase

Data Source Eurobarometer 1975-1992 (1-4, life satisfaction)

Eurobarometer 1992-2002 (1-4, life satisfaction)

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Inflation Source Values Wolfers Level: Down by 2003 0.007 SDs (SE 0.003) [0.2% of population] Welsch Level: .011 (t-stat 2007 1.00) wrong direction Change: -0.035 (tstat 1.30) Without interest rates: -0.044 and -0.068 Di Tella, MacCulloch, and Oswald 2001 Level: -1.2 (SE 0.3) Change: -0.7 (SE 0.4)

Interpretation Level: 0.2% of population falls one category with 1 point increase Level (Change): If significant, 1.1% (0.35%) would increase (fall) one category with 1 point increase

Data Source Eurobarometer 1973-1998 (1-4, life satisfaction) Eurobarometer 1992-2002 (1-4, life satisfaction)

Di Tella, Level: -0.994 (SE MacCulloch, 0.464) and Oswald 2003

Level (Change): If significant, 1.2% (0.7%) would fall one category with 1 point increase Level: 1.0% of population falls one category with 1 point increase

Eurobarometer 1975-1991(1-4, life satisfaction)

Eurobarometer 1975-1992 (1-4, life satisfaction)

Interest Rates Source Values Welsch 2007 Level: -0.050 (tstat 5.00) Change: -0.398 (tstat 6.42)

Interpretation Level (Change): 5% (39.8%) of population decreases one category with 1 point increase

Data Source Eurobarometer 1992-2002 (1-4, life satisfaction)

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This thesis represents my own work in accordance with University Regulations. I authorize Princeton University to reproduce this thesis by photocopying or other means, in total or in part, at the request of other institutions or individuals for the purpose of scholarly research.

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