With Labor Day weekend fast approaching and gas prices reaching $1.79 a gallon in many markets and even topping $2.00 a gallon for premium unleaded, newspapers have been full of headlines about "record prices." But the talk about record highs is based on a common economic fallacy -- a failure to adjust for inflation over time. General inflation raises the overall level of prices throughout the economy. The real issue is whether gasoline prices are rising relative to the other costs of goods and services. And if we measure energy and gas prices correctly, we find that gasoline, although the price has risen by more than 20 percent in recent weeks, is still affordable in historical terms.
The Energy Information Administration reports gasoline prices in both nominal and real terms. The real prices are adjusted for the effects of inflation by applying the implicit GDP price deflators to compare prices in constant 1996 dollars. As the chart shows, the current "record high" price is quite moderate by historical standards. We had higher retail gasoline prices as recently as 1985, and significantly higher prices from 1979 to the mid 1980s.
The late great economist Julian Simon, a Cato Institute adjunct scholar, was famous for teaching us that it is most important to look at the very long term trends in prices of natural resources, if one wants to make predictions about the future. Here is what Simon's long term data on energy and gas prices tells us. Gasoline prices paid at the pump have been on a steady rate of decline since the 1920s, with the obvious exception of the 1970s, when we faced an OPEC embargo and gasoline lines. In 1920 the real price of gas (excluding taxes) was twice as high as today. If the price of gasoline relative to wages were comparable today to what they were in 1920, we would be paying almost $10 a gallon for gas. (See The State of Humanity, by Julian Simon, Blackwell Publishers, 1995, Chapter 28.)
The same is true, by the way for the cost of electricity and oil. Oil is slightly cheaper today adjusted for wage growth than it was 50 years ago and 5 times cheaper than 100 years ago. Electricity in to our homes is about one-half as expensive as 50 years ago, and despite the recent black outs, the service is more, not less reliable.
Time Magazine recently published a major story warning that the world is running out of energy. The authors of that story, Donald Barlett and James Steele, are completely misinformed. Given new technologies in the energy industry and the new oil deposits being found in Russia and other nations around the world, the likelihood is that prices of gasoline, oil, and electricity will fall throughout the 21st century, just as they did in the 20th. If Julian Simon were still alive, he would gladly bet Barlett and Steele or any other pessimists a tidy sum that prices will fall not rise over time. He has at least 100 years of history on his side. And he never lost a bet.
One last word on the rising cost of gasoline. American motorists should be mighty pleased that the United States does not adopt the economically dysfunctional high-energy tax policies that are commonplace in Europe. In the Euro nations gasoline often reaches $4 a gallon with more than half the price collected in taxes. Perhaps $2 a gallon gasoline is a bargain after all.