Gas Prices are High, But Don’t Blame the Usual Suspects: Implications for Policy

A.  Introduction

Gasoline prices in the US (and indeed elsewhere) are certainly high.  Given that in the US much of the voting population views cheap gas as much of a right as life, liberty, and the pursuit of happiness, this has political implications.  It is thus not surprising that politicians, including those in the Biden administration, are considering a range of policy measures with the hope they will bring these gas prices down.  And while fuel prices have indeed come down some in the last few weeks from their recent peak, they remain high, and their path going forward remains uncertain.

One of the most common such measures, already implemented in six states (as of July 6) and under consideration in many more, has been to reduce or end completely for some period state taxes on fuels.  And President Biden on June 22 called on Congress to approve a three-month suspension of federal gas and diesel taxes.  The political attraction of such proposals is certainly understandable.  A Morning Consult / Politico public opinion poll in March found that 72% of those surveyed would favor “a temporary break from paying state taxes on gasoline”, and 73% would favor a similar “temporary break from paying federal taxes on gasoline”.  It is hard to find anything these days that close to three-quarters of the population agree on.

But would this in fact help to reduce what people are paying at the pump?  The answer is no.  One has to look at what led to the recent run-up in gas and other fuel prices, and only with a proper understanding of that can the appropriate policy response be worked out.  Cutting taxes on fuels should not be expected to lead to a reduction in what people pay at the pump for their gas.  Indeed, what could lower these prices would be to raise fuel taxes, and then use the funds generated to cover measures that would, in the near term, reduce the demand for these fuels.

This post will first examine the recent run-up in fuel prices, putting it in the context of how that market has functioned over the last decade and what is different now.  Based on this, it will then look at what the impact would be of measures such as cutting fuel taxes, releasing crude oil from the nation’s Strategic Petroleum Reserve, encouraging more drilling for oil, and similar.  None of these should be expected, under current conditions, to lead to lower prices at the pump.

Rather, one could raise fuel taxes and use these funds to support measures that would reduce the nation’s usage of gas.  For example, an immediate action that would be effective as well as easy to implement would be to encourage ridership on our public transit systems by simply ending the charging of fares on those systems.  One could stop charging those fares tomorrow – nothing special is needed.  Some share of those driving their cars for commuting or for other trips would then switch to transit, which would lead to a reduction in fuel demand and from this a reduction in fuel prices.  The lower price will benefit all those who buy gas, including those in rural areas who have no transit options.  And as will be discussed, the cost to cover what is being collected in fares would be really quite low.

A note on usage:  All references to “gas” in this post are to gasoline.  They are not to natural gas (methane) nor indeed any other gas.  Fuels will refer to gasoline and diesel together, where statements made with a specific reference to gas will normally apply similarly to diesel.

B.  The Rise in Fuel Prices and the Factors Behind It

Fuel prices have certainly gone up in the first half of 2022.  As shown in the chart at the top of this post, despite the fall in recent weeks fuel prices (the line in red) are still 75% above where they were in early-December (in June they were more than double), with those December 2021 prices double what they had been in October / November 2020.  Crude oil prices (the line in black) have also been going up, and have been since late 2020 (following the dip earlier in 2020 due to the Covid lockdowns).  This rise in the price of crude oil can explain the rise in the retail prices for fuels up through early this year.  But as we will discuss, the factors behind the more recent rise in fuel prices changed in late February 2022 – coinciding with Russia’s invasion of Ukraine.

First, some notes on the data.  The figures all come from the Energy Information Administration (EIA), part of the US Department of Energy, and weekly averages are used.  For reasons to be discussed below, the price of “fuel” is a 2:1 weighted average of the prices of regular unleaded gasoline (unleaded) and diesel (ultra low-sulfur no. 2), both wholesale FOB spot prices and for delivery at the US Gulf Coast.  While it is an average, this does not really matter much in practice as the wholesale prices of gas and diesel have not, at any point in time, differed by all that much from each other.  They move together.  Nor have their average prices over time differed by all that much.  For the period since the start of 2014, the average wholesale cost of gas was $1.81 per gallon while that for diesel was $1.90 – a difference of just 9 cents.  While there can be larger differences at various points in time, for the purposes here the distinction between the two fuels is not central.

The cost of crude oil (the line in black) is for West Texas Intermediate (FOB spot price, for delivery at Cushing, Oklahoma), the benchmark crude most commonly used in the US and also the basis for the main financial contracts used to hedge the price of oil in the US.  It is presented here on a per-gallon basis to make it comparable to the other prices, where one barrel of oil is equivalent to 42 gallons.

A refinery will purchase crude oil and then through various processes refine that oil into gasoline, diesel, and other petroleum products that can then be used as fuels by our cars and trucks as well for other purposes.  The difference in price between what the refinery can sell these finished products for and the cost of the crude it buys as the primary input is called the “crack spread”.  While the crack spread will be unique for each refinery, as it will depend on the technology it has (how modern and efficient it is), what types of crude it has been designed to process most efficiently (as different crudes have different characteristics, such as viscosity and sulfur content), the mix of specific products it produces (the share ending as gas or diesel, but also jet fuel, heating oil, etc.), and the location of the refinery (as the crude oil must be delivered to it, and it then must arrange for the delivery of its products to the ultimate purchasers), a simplified standard spread is often calculated to provide an indication of how market prices are moving.  The most common such standard spread is called the “3-2-1 crack spread”.

The 3-2-1 crack spread is calculated for a refinery that would process 3 barrels of crude oil into 2 barrels of gasoline and 1 barrel of diesel.  For the calculations here, all were expressed on a per-gallon basis, and the specific fuels and delivery locations are as specified above.  The 3-2-1 crack spread is then simply calculated as the value of two gallons of gasoline plus one gallon of diesel, minus the cost of three gallons of crude oil, with that total then divided by three as three gallons of fuel are being produced.  It is a gross spread, as a refinery will of course have other operational costs (including the cost of labor), plus the refinery will need to generate a return on the capital invested for it to be viable in the long term.  But this simple gross spread is often used as an indicator of what is happening in the market.

That calculated 3-2-1 crack spread is presented as the blue line in the chart at the top of this post.  From 2014 through 2021, it rarely moved above $0.50 per gallon, and it averaged just $0.36 per gallon over the period.  In 2021 it was not much higher, averaging $0.42 per gallon over the year.  But from late February 2022, coinciding with the Russian invasion of Ukraine, it has shot upward.  As of the week ending June 24 it had reached $1.46 per gallon, but as of the week ending July 8 it had come down to $1.02.  That is still high – it is still close to three times what it had averaged before.

To understand the factors that led to this jump in the crack spread this year, one should first consider how prices are determined in these markets.  The key is that the crack spread is not itself an independently determined price, but rather a spread between the price of the final product (gasoline and diesel fuels) and the price of crude oil, both of which are determined independently.

Start with the final products – gasoline and diesel:  These are sold in highly competitive markets of numerous gas stations pricing their product to sell at the best prices they can get, but where for the nation as a whole, stocks of the fuels are kept within a narrow range.  One can calculate (again from EIA data), that in recent years (2017 through 2022H1), the nation’s stocks of motor gasoline have averaged 236 million barrels, with no clear upward or downward trend.  While the stocks will vary over the course of the year due to seasonality, at comparable weeks in the year they have been kept in a relatively narrow range, with a standard deviation of just 2.1% of the weekly averages over this period.  This means (assuming a normal distribution, which is reasonable) that in about two-thirds of the weekly cases, the stocks will be within +/- 2.1% of the average for those weeks (one standard deviation), and in 95% of the cases will be within +/-4.2% of the averages (two standard deviations).  That is, the stocks are managed to stay within a relatively narrow range, although at a target level that depends on the season of the year.

In such a market, if producers (either directly or through the gas stations they contract with) price their gasoline at too low a price for the conditions of the time, they will find that their stocks will be running down – soon to unsustainable levels.  They would need to ration what they sell, either by long lines at the pumps or by some direct rationing system.  And if they price their gasoline at too high a price, they will find their stocks accumulating to levels that exceed what they can store.  They sell their gas for the highest price they can get, but that price will be constrained to be such that they will be able to manage their inventories of refined gasoline (and similarly for diesel fuels) to within a certain range.  And as noted above, that range is a narrow one of normally just +/- 2% or so.

Crude oil prices are determined differently.  Here there is a world market, where OPEC producers (as well as a few producers who cooperate with OPEC, where the most prominent is Russia) set production ceilings by OPEC member (and cooperative partner) with the aim of achieving some price target.  They do not always succeed in achieving that target, as global conditions can change suddenly.  Recent examples include conditions triggered by the Covid crisis in 2020, or by the global financial crisis that began in the US in 2008.  OPEC also responds sluggishly to changes in the markets, particularly when crude oil prices are rising – which many OPEC members are rather pleased with – as the production quotas must be negotiated among the members.  But it is correct to say that the market for crude oil is a managed one, although often not a terribly well managed one due to the inherent difficulty in forecasting global demands and then responding on a timely basis to unexpected changes.

With the retail price of the fuels determined on the one side by conditions in the competitive markets for fuels, and the price of crude oil determined on the other side by the actions of OPEC and those who cooperate with it, the crack spread will be a margin that has now been determined.  That is, it is not a price that the refiners themselves will normally be able to set.  There is a lower limit, as a gross crack spread that is too low to cover their other operating costs (and is expected to stay that low for some time), will lead refiners to shut down their operations.  But based on what we observe for the period from 2014 in the chart at the top of this post, it appears that a crack spread of $0.36 per gallon (the average from 2014 through 2021) is sufficient to cover such costs as well as provide a return on the capital invested, as refineries stayed open and continued to produce over this period with such a spread.

This spread then jumped in late February of this year – coinciding with the Russian invasion of Ukraine – to a level that has been between three and four times what it was before.  What happened?  While the Russian invasion was clearly significant, one should look at this in the context of where the market was just prior to the invasion.  It was tight, and the Russian invasion should be seen as a tipping point where refinery supplies of these fuels could no longer meet the demand.

First of all, demand has been growing, both in the US and in the rest of the world, as economies have recovered from the lockdowns that were necessary at the start of the Covid crisis.  The US enjoyed a particularly strong recovery in 2021, with real GDP growing by 5.7% – the fastest such growth in any calendar year in the US in close to 40 years.  And the personal consumption component of GDP rose by 7.9% in 2021 – the fastest such growth in any year since 1946!  But it should be recognized that this was coming after the sharp falls in 2020 due to Covid (of 3.4% for GDP and 3.8% for personal consumption).  The rest of the world recovered similarly in 2021, although at various different rates.

This raised the demand for gas, diesel, and other fuels.  Petroleum refineries could keep up in 2021, as this followed the lower demands they had for their products in 2020.  But the lower demands (and hence lower refinery throughputs) in 2020 due to Covid did have an effect.  It led to decisions to close some of that refinery capacity, leading to a reduction in capacity in 2021 for the first time in decades.  Albeit small, worldwide, refinery capacity fell from 102.3 million barrels per day in 2020 to 101.9 million barrels in 2021 (a fall of 0.4%).  Refinery capacity in the US fell similarly, from 18.1 million barrels per day in 2020 to 17.9 million barrels in 2021 (a fall of 1.1%).  With the recovery in demand for fuel products in 2021, this placed producers at closer to their limits.

But the limit to how much petroleum refineries can produce is pretty rigid.  They normally operate on a continuous, 24-hours a day, basis – at a rate as close as possible to their design capacity.  Thus they cannot increase production by adding an extra work shift or by running processes at a faster rate.  They do need to shut down periodically for preventive maintenance, as their systems are complex and they must deal with flammable liquids that are being processed at often high temperatures and pressures, where a failure of some part can lead to a catastrophic explosion.  They must also shut down on occasion for safety reasons, such as when a hurricane or other major storm threatens (an increasingly frequent occurrence in recent years in the US Gulf Coast, where much of the US refinery capacity is located, due to climate change – such weather-related shutdowns are discussed further below).  In general, then, refinery throughput is highly constrained in the short run by existing available capacity, which is being run continuously at as high a rate as they can.

Over the longer term, refinery capacity will depend on what investments are made to expand that capacity.  But new refineries cost billions of dollars, are rare, and when undertaken take many years to plan and then build.  Significant expansions in existing refineries are also very costly, and also require significant time to plan and then build.  Thus such investments are very carefully considered and are only made when they expect there will be a demand for the products of those refineries for many years to come – at least a decade or more.  It is not something they rush into.  Even if capacity is tight right now, such investments will not be made unless the owners expect those conditions to last for an extended time.  And even if the decision is made to make such an investment to expand capacity, it will normally take years before the added capacity will become available.

Thus in the near term, when one is already operating at close to the design limits of the refineries it will not be possible to supply much more than what the existing available capacity will allow.  Economists call this “inelastic supply”, as the percentage increase in supply of some product for some given percentage increase in the price that would be paid for that product (an “elasticity”) is low.  For refineries that are already operating at close to their technical limits, it will be very low.

The other factor in price determination is demand.  And for fuels such as gas or diesel, many will say the price elasticity of demand for such fuels is also low.  Indeed, a common view in the general population is that the price elasticity of demand for gas is zero – that they will have to buy the same number of gallons each week whatever the price is.  This is not really true (and contradicted by the assertion that they also cannot “afford” to pay more – if true, then at a higher price they will have to buy less).  But studies have found that while not zero, it is low.

For example, the Energy Information Agency in 2014 estimated the price elasticity of demand for gasoline in the US was just -0.02 to -0.04.  That is tiny.  It implies that if the price of gas were to rise by 10% (say from $4.00 to $4.40 per gallon), the demand for gas would decline only by 0.2 to 0.4%.  Other estimates that have been made have often been somewhat higher, although still low.  A widely cited review in 1998 by Molly Esprey, for example, examined 300 published studies, and found that the median estimate of this elasticity across those studies was -0.23.  This is still low.  It implies that a 10% increase in the price will be met by only a 2.3% fall in demand.

With a demand for fuel that does not go down by much when prices rise, and a supply for fuel that does not go up by much when prices rise (i.e. when refineries are already operating at close to their capacity), one should expect prices for fuels to be volatile.  And they are.  Even small shifts in the available supply or in the demand can lead to big changes in prices.

In these already tight markets of early 2022, Russia then invaded Ukraine on February 24.  The crack spread rose from $0.49 per gallon for the week ending February 25, to $0.64 the following week and to $0.74 the week after that.  It reached $0.88 by the end of March and $1.35 by the end of April.  As of the week ending June 24 it had reached $1.46, but then came down to $1.02 two weeks later.

The Russian invasion not only affected production at refineries in Ukraine, but international sanctions on Russia meant a significant share of Russian refineries would also no longer supply global markets.  While refineries in Ukraine are not a significant share of global capacity (just 0.2% in 2021), refineries in Russia are significant, with a 6.7% share of global capacity in 2021.  As a comparison, US refineries account for 17.6% of global capacity.

One should note that this does not mean that global capacity was effectively reduced by 6.7% of what it was.  Russian refineries continued to produce for their own markets, while also supplying others.  But the sanctions have reduced the volume effectively available by a significant amount.

In a market that was already tight, with refineries operating at close to capacity following the strong recovery demand in 2021 in the US and much of the world, such a reduction in effective supply acted as a tipping point.  The 3-2-1 crack spread shot up immediately.

C.  Policy Implications

What, then, can be done to reduce fuel prices?  I will take it as a given that that is the objective.  A case could well be made that to address climate change and the consequent need to reduce the burning of fossil fuels, high prices are good.  But while important, that is a separate issue I am not trying to address in this post.

First, where are gas prices now?:

The figures here are based on data gathered by the Bureau of Labor Statistics (BLS) for its calculations of the monthly CPI.  The figures are a consistent series going back to 1976 (further back than any other consistent series I have been able to find), are available in current price terms per gallon, and are not (here) seasonally adjusted so they reflect the actual prices paid that month.  And like the overall CPI that is commonly cited, it is an estimate of prices in urban areas.

As of June 2022, the average retail price of regular unleaded gasoline in the US was $5.058 per gallon.  For the chart, I have then shown what the historical prices would have been when adjusted for general inflation to the prices of June 2022 (based on the overall CPI).  The June prices are not the highest gas prices have been – they hit $5.51 a gallon in July 2008 – but they are close.  Although declining in recent weeks as I am writing this, it remains to be seen whether gas prices might resume their upward trend sometime soon.  The markets continue to be volatile, and prices could soon set a new record.

Whether that will happen will depend in part on what the policy response now is.  There are measures that can be taken that will reduce prices, but also measures that are being discussed that would likely have little effect, or might even raise prices. In this section, I will first discuss why, given the underlying causes of the price increases this year discussed above, some of the measures being discussed will likely do little and might indeed be counterproductive.  I will then discuss measures that could help lead to a reduction in prices.

1)  What Not To Do

First, some policies that will not lead to lower prices, or might even lead to higher prices:

a)  Perhaps the most widespread assumption is that if OPEC produced more crude oil, gasoline prices would then fall.  But that should not be expected given the current situation.  As seen in the chart at the top of this post, the crack spread widened sharply starting in late February, as a certain share of global refining capacity became not usable.  In the already tight markets refinery capacity became the effective binding constraint, not the price of crude oil.

More crude oil production by OPEC (or indeed by anyone) could well lead to lower crude oil prices – and indeed likely would.  But unless more of that crude oil can be refined into final fuel products such as gasoline, the available supply of gas in the market would not be affected.  Retail prices would remain the same.  What would change is that if crude oil prices decline by some amount with the increased supply of crude, the crack spread would widen.  That is, refiners would gain by this.  Consumers would not.

b)  For the same reason, sale of crude oil out of the Strategic Petroleum Reserve should not be expected to lead to lower retail prices for gas either.  President Biden announced on March 31 that the US would start to sell one million barrels of crude oil per day (an unprecedented amount) out of the US Strategic Petroleum Reserve for at least six months.  This announcement may well have had some effect on crude oil prices:  Crude oil prices had been rising through late March and then fell a bit (before returning to March levels in late May, and then continuing to rise until mid-June).  But this did not affect retail prices for fuels, which continued to rise until the last few weeks.  Rather, the crack spread rose (as seen in the chart at the top of this post) as refiners were able to obtain a larger margin between what they could sell their products for and what they had to pay for their crude oil.

c)  Also popular has been the proposal to reduce or eliminate taxes on the sale of gas and other fuels.  The federal tax is 18.4 cents per gallon on gasoline and 24.4 cents on diesel, while state taxes are of varying amounts.

President Biden on June 24 called on Congress to approve a temporary suspension of federal taxes on gas and diesel for three months.  As of my writing this, Congress had not approved such a suspension (it would complicate infrastructure funding, as such funding is linked to fuel tax revenues), and it does not look likely that it will.  But one never knows.  And as of July 6, six states had suspended their state fuel taxes for varying periods, with many more considering it.

What effect would such a tax cut have?  First, consider the federal tax, as it applies across the entire country.  As discussed above, the supply of fuels such as gas and diesel is constrained by available refinery capacity.  Economists refer to this as operating where the supply curve is “vertical”, in that a higher price for the fuel cannot elicit a significant increase in the supply of the fuel in the near-term, due to the capacity constraint.  A lower tax will not then lead to a lower price, as a lower price (if one saw it) would lead to greater demands for the fuels and refiners cannot supply more.  In such a situation, refiners are earning a rent, and a lower tax to be paid on the fuels will just mean that the refiners will be able to earn an even larger profit than they are already.  The crack spread will go up by the amount the tax on fuels is reduced.

The situation would be different if refiners could supply a higher amount.  Retail prices would fall by some amount due to the reduction in the tax, supplies would rise by some amount, and in the end consumers and refiners would share in the near-term gains from the lower tax.  What those relative shares will be will depend on how responsive the supply of fuels would be from the refiners (the elasticity of supply).  In the extremes, if refiners are able and willing to supply the increase in demand at an unchanged price (the supply curve is flat), then retail prices will fall by the entire amount of the tax cut and consumers will enjoy all of the benefit.  But if refiners are unable to supply more due to capacity constraints, then retail prices will be unchanged by the tax cut and refiners will pocket the full amount of the tax cut.  Currently, we are far closer to the latter set of circumstances than to the former.

The situation is a bit different at the state level.  If one state cuts its taxes while the taxes remain the same elsewhere, refiners will be able to move product to meet the higher sales of fuels in the state where taxes were cut.  This would, however, be at the expense of lower supply in the states that did not cut their taxes.  Fuel prices in the state cutting its taxes (and not matched by others) will fall by some amount due to the now higher availability of fuels in that state.  But with the overall supply constrained by what the refineries can produce, the lower amounts supplied to the rest of the country will lead to higher prices in the rest of the country.

Overall there will be no benefit, and indeed on average prices (net of taxes) will rise.  But there will be some redistribution across the states.  The amount will depend on what share of the states decide to cut their taxes.  At one extreme, if only one state does it and that state does not account for a large share of the overall US market, then the retail price (inclusive of taxes) will fall in that state.  If that state is small, prices elsewhere in the country would only rise by a small amount, but they still would rise.  But if more and more states decide to cut their fuel taxes, then one will approach the situation discussed above with the cut in federal taxes on fuels.  The full benefits of the lower taxes will accrue to the oil refiners, not to any consumers.

Finally, one needs to recognize that there is no free lunch.  The states cutting their fuel taxes will need to make up for the revenues they consequently lose.  To fund the expenditures paid for by the fuel taxes (often investments in road and other infrastructure), those states would need to raise their taxes on something else.

2)  What To Do

So what would lead to lower fuel prices given the current conditions?  The simple fact is that for prices to go down, one will need either to increase the supply of the refined products, or reduce the demand for them.  Taking up each:

a)  As was discussed above, refineries normally operate at close to their maximum capacity, and there is not much margin to respond to unforeseen demands.  Refineries are expensive, hence are not designed with much excess capacity to spare, and when operating are operated on a continuous, 24-hour a day, basis.  They also need to be shut down periodically for scheduled maintenance, as well as when unscheduled maintenance is required or when a strong storm threatens.

Still, there might be some measures that can be taken to push refinery throughput at least a bit higher.  Refiners certainly have an incentive to do so, given how high the crack spread is now (three to four times higher in recent months than what it was on average between 2014 and 2021).  But the crack spread does not need to be anywhere close to that high to provide a strong incentive.  A spread that is double what it would be in more normal times should more than suffice to elicit refiners to do whatever they can to maximize refinery throughputs.

There will also be an element of luck, given the increasingly volatile weather conditions that climate change has brought.  One can see this in a simple snapshot of a chart available on the EIA website, showing idle US refinery capacity (which is more properly measured by and referred to as distillation capacity) by month going back to 1985:

Volatility rose significantly starting in 2005 (the year of Hurricanes Katrina and Rita) and has been high since.  The sharp peaks seen in the chart are all in September or October – the peak months of hurricane season for the US.  Especially prominent peaks in the capacity that had to be idled were in September 2008 (Hurricanes Gustav and Ike), September 2017 (Hurricane Harvey), and September 2021 (Hurricane Ida).  With hurricanes threatening, refineries must be shut down for safety.  How fast they can then reopen depends on how much damage was done, but will require some time even if there was only limited damage.

It is impossible to say what will happen in the upcoming hurricane season.  But with the market so tight, any closures could have a large impact on prices.

b)  The other side to focus on is demand.  This could also be more productive in the near term given that little more may be possible on the supply side (as well as subject to chance, given the uncertainty in what will happen in the upcoming hurricane season).  But progress on demand-side measures will depend on political will, and Americans have been historically averse to measures that would reduce the near-term demand for fuels.

But it is important to recognize that not much would be needed in terms of reduced demand in order to reduce fuel prices by a substantial amount.  This is precisely because the demand for fuels is so price inelastic, as discussed before.  That is, a substantially higher price for gas does not lead to all that much of a reduction in the quantity of it purchased.  What economists call the “demand curve” (the amount purchased at any given price) is close to vertical.  When this is coupled with an also close to vertical supply curve for refined products (as refineries are operating close to their capacity, and cannot produce more no matter what price they can get), small shifts in the amount demanded at any given price will have a major effect.

[An annex at the end of this post uses simple supply and demand curves to examine this graphically.]

Given this lack of sensitivity to price under current conditions for both supply and demand, it would not take all that much to get prices to fall by a substantial amount.  Supply of refined products is constrained by refineries operating at close to their maximum, while on the demand side, purchases of fuels do not adjust by much when prices change.  As was noted above, the EIA in 2014 published an estimate of the price elasticity of demand for gasoline of just -0.02 to -0.04.  That implies that a 10% rise in the price of gas would reduce demand by only 0.2 to 0.4%.  Others have estimated higher elasticities, but all still relatively low.

Suppose, for the sake of illustration, that the price elasticity of demand was -0.10, so that a 10% rise in the price would lead to a reduction in demand of 1%.  This relationship also tells us a good deal about the shape of the demand curve – specifically its slope (locally).  If facing a completely vertical supply curve, then it implies that a 1% reduction in the demand for gasoline at any given price (meaning a shift in that demand curve to the left by 1%) would lead to a new price that is 10% lower than before.  And a 2% shift would lead to a price that is 20% lower.  While extrapolating in this way from what might be true for small changes to something substantially larger is dangerous, a 20% fall in the price of gas that is at $5.00 per gallon would lead to a new price of $4.00 per gallon – all resulting from just a 2% shift in the demand.  This is substantial but depends, as noted above, on how responsive demand is to the price.  If truly not very responsive, as is commonly held by many, then it will not take much of a reduction in demand (at any given price) to lead to a very substantial reduction in the price.

How, then, might one reduce the demand for fuels?  One possibility would be to encourage more work from home.  One saw the effect of this on fuel demands (and hence prices) in 2020, when working from home was required for health reasons at the start of the Covid crisis.  Workers are now returning to the office, but perhaps our political leaders should encourage a delay in this, or at least a slower pace on the return.  But it probably could not be mandated, and indeed probably should not be simply for the sake of cutting the price of gasoline.  And while opinions differ on this, some would say that extending work-from-home even further will reduce worker productivity.

A better way to reduce fuel demands would be to provide a greater incentive to take public transit rather than drive a car for a higher share of the trips one undertakes.  One could do the following:  First, raise tax revenues that could be used for these measures by raising federal taxes on fuels by, say, $0.25 per gallon.  As was noted above, when one is operating with a vertical supply curve, as we are now, increasing taxes on fuels will not lead to higher prices for the consumer.  The crack spread would fall, but with that spread that has varied between $1.00 and $1.50 per gallon in recent months, a higher fuel tax of $0.25 per gallon would still leave that crack spread at two to three times the $0.36 it averaged before.

According to EIA data, the total supply of motor gasoline in the US averaged 9.3 million barrels per day between 2016 and 2019 (taking a four-year average, and excluding 2020 due to Covid), while diesel supply averaged 4.0 million barrels per day.  Mutliplying this sum of 13.3 million barrels per day by 42 gallons per barrel and 365 days per year, the annual supply of these fuels averaged 204 billion gallons.  Rounding this to 200 billion gallons, a tax of $0.25 per gallon would raise $50 billion on an annualized basis.

This could be used to support public transit.  Something that could be done instantly (starting literally the next day) would be simply to stop charging fares on public transit systems – including buses, rail (subways), commuter trains, and whatever.  According to the National Transit Database, in 2019 all these public transit systems generated a total of $16.1 billion in revenues, mostly from fares but including also other locally-generated revenues such as from the sale of advertising.  (Again, 2020 was an unrepresentative year due to Covid so it is better to use 2019 figures.)  The database does not separate out fares from other revenues, but even if one treated it all as fares, the $16 billion needed would be far below the $50 billion that would be generated (on an annualized basis) by increasing the federal tax on gasoline and diesel by $0.25.

Filling empty seats on buses and subways also does not cost anything.  Indeed, operating costs would in fact go down by not having to collect fares.  There are significant direct costs in collecting fares (and to ensure too much is not stolen), but one would also gain operational efficiencies.  Buses now take a relatively long time to cover some route in part because at each stop people have to line up and go one-by-one through the front door to pay their fares in some way.  Not having to take so long at each stop would allow the buses to cover their routes at a faster pace.  This would increase effective capacity or, if capacity were to be kept the same as before, one could provide that capacity with fewer buses and their drivers.

The aim is to shift people from driving their cars to taking public transit for a higher share of the trips they take.  To the extent this simply fills up some of the empty seats, there is then no additional cost.  But if ridership increases by a substantial amount (something to hope for), capacity would need to grow.  This could most easily be accommodated by additional buses.  This would cost something, but according to the National Transit Database figures, the total spent in 2019 from all sources (federal, state, and local), for all modes of public transit, for both operating and capital costs, was $79 billion.  With the $34 billion left after using $16 billion to cover fares (out of the $50 billion that the $0.25 per gallon would collect), one could cover an increase in spending on public transit of more than 40%.  This would be far more than what would be needed even with a huge increase in ridership.  But we are now going beyond the very short-term measures that could be taken to reduce fuel demand.  However, with the long-term need to reduce the burning of fossil fuels, it is good to see that even a relatively modest fee of just $0.25 per gallon of fuel could support such an expansion in public transit.

Such an approach would lead to a reduction in the demand for those fuels.  How much I cannot say with the information I have, but it should be substantial.  And as discussed before, even a small reduction in the demand for these fuels should lead to a substantial fall in their price.  That fall in price would also be of benefit to all those who purchase these fuels, including those in rural areas who are far from any public transit option.  It would be a mistake to presume that stopping the collection of fares on public transit systems would only be of benefit to the users of public transit.

D.  Concluding Remarks

The price of gas is certainly high.  Although not quite a record (when general inflation is accounted for) it is close.  This has led to a number of proposals aimed at reducing those prices.  Particularly popular politically has been to cut fuel taxes for at least some period, with this championed both by President Biden (for federal fuel taxes) and in a number of states (where several have done this already for the state-level fuel taxes).  Many also blame OPEC for managing supplies in order to drive crude oil prices higher.  To address this, there have both been major sales out of the Strategic Petroleum Reserve (of one million barrels of crude a day), as well as diplomacy to try to get others to boost their supply of oil.

Under current market conditions, however, these initiatives should not be expected to reduce prices.  The issue right now is that refineries are the binding constraint.  They are producing as much of the refined products (fuels, etc.) as they can, but limits on their capacity keep them from producing more.  One sees this in the crack spread, which jumped up in late February immediately following the Russian invasion of Ukraine.  A substantial share of Russian refinery capacity became unusable, and this served as a tipping point in an already tight market.

Under such conditions, a lower price for crude oil will not lead to lower retail prices for fuels.  While it would benefit refiners (the crack spread would widen), the prices at the pump would not be affected unless refiners were somehow then able to raise their production.  Similarly, a cut in fuel taxes should not be expected to lead to lower fuel prices at the pump.  Rather, refiners would receive a windfall as they would receive a higher share of the retail price.  Refiners are already doing extremely well, with a crack spread in recent months that has been three to four times what it averaged between 2014 and 2021.  There is no need to make this even more generous.

To reduce retail prices, one should instead reduce demand.  One measure that would do this would be simply to stop charging fares on public transit.  Inducing only some of those now driving to use transit more often could have a significant impact on prices.  This is because the demand for fuels is not terribly responsive to price (consumers in the US do not cut back on their car use all that much when prices are higher), at the same time as the supply of fuels is limited by refinery capacity (so the supply of fuels cannot go up by much despite higher prices).  With both the demand and supply curves close to vertical, a small shift left or right in the curves can have a big impact on prices.

It would not cost all that much to end the collection of transit fares either.  Not only can it be done instantly (simply stop collecting), but the total public transit systems received in 2019 in fares paid (as well as in other revenues, such as from advertising) was only $16 billion.  One could easily cover this by increasing the federal taxes on fuels.  As noted above, a cut in fuel taxes would not lead to lower fuel prices.  For the same reason, an increase in fuel taxes (within limits) would not lead to higher fuel prices.  And just a $0.25 per gallon increase in federal fuel taxes would raise roughly $50 billion on an annualized basis.

It should be kept in mind that all this is based on current market conditions.  Those conditions can change, and change suddenly – as we saw in late February with the launch of the Russian invasion.  Thus, for example, while the crack spread is currently very high, this is in part a function of where crude oil prices are.  As of the week ending July 8, the price of West Texas intermediate was $103 per barrel.  With gas and diesel prices where they were then, the crack spread was $1.02 per gallon – far above the $0.36 per gallon it had averaged between 2014 and 2021.  But at a higher price for crude oil, the crack spread would fall.  At $131 per barrel (and with gas and diesel prices where they were as of the week ending July 8), the crack spread would be back at $0.36 per gallon.  And at $146 per barrel, the crack spread would be zero.  Presumably, if crude prices approached such a level refiners would cut back on production, leading to higher gas and diesel prices.  Crude oil prices would then be the binding factor, and efforts to lower those prices (e.g. by sales out of the Strategic Petroleum Reserve, or more OPEC production) could then matter.

The point of this blog post is that that is not where we are now.  Current conditions call for a different policy response.

 

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Annex:  Supply and Demand Curves to Show the Impacts of the Options

For those of you familiar with simple supply and demand curves, it is easy to see the impacts of the policy options discussed verbally in the text above.

The supply curve of fuels from refineries slopes upward from a curve that is relatively shallow to something increasingly steep and ultimately to vertical.  At relatively low levels of production, where there is a good deal of excess capacity in the refineries, a small rise in prices for the fuels will elicit a strong supply response.  But as production approaches the maximum capacity of what the refineries can produce (in the near term, given existing plant), there can only be little and ultimately no more production no matter how high the price goes.

The demand curve is steep.  That is, if prices rise by some amount, the quantity of fuels demanded does not fall by all that much.  The price elasticity of demand is low.

Retail taxes per gallon of fuel add to the supply cost.  That is, in the figure above, the red curve (marked S2) is what the supplies would be at some lower (possibly zero) retail fuel tax per gallon sold, while the blue curve (marked S1) is what the supply would be at some higher tax rate.  The supply curve will shift upwards.  That is, for any given quantity of supply, a higher price will be needed for that amount to be supplied.

When the supply curve is relatively shallow and upward sloping, as in the lower left of the diagram, then a cut in the tax (from the blue curve to the red), with a demand curve such as D3, will lead to some increase in supply and a significantly lower price.  The price, in the diagram, would fall from P3 to P4.  This is the logic behind the proposals, such as have been made by President Biden, for a temporary cut in federal fuel taxes.

However, this is not where current market conditions are.  Rather, refineries are operating at close to their maximum capacity, and one is in an area where the supply curve is close to vertical.  When the supply curve is vertical, a reduction in fuel taxes will simply shift that vertical curve downwards, but with one vertical curve simply sitting on top of the other vertical curve.  While a reduction in the tax per gallon will increase how much the refiner receives, after taxes, it will not lead to a higher amount being supplied (refiners cannot produce any more) nor will it lead to a lower price for consumers.  The lower taxes will simply be reflected in higher profits for the refiners.

In terms of the supply and demand curves depicted above, one would be in an area such as that depicted with the demand curve D1 with a price of P1.  If the supply curve is shifted downwards due to the tax cut (from the blue curve S1 to the red curve S2), with nothing done to affect the demand curve, then the price remains at P1.

In contrast, if the market conditions are such that the demand curve is at D1 and the supply curve is close to vertical, yielding a price of P1, a relatively modest shift in the demand curve to the left, i.e. from D1 to D2, leads to a sizeable fall in the price – from P1 to P2.  The fall in the price is large because both the demand curve and the supply curve are steep, and indeed close to vertical for the supply curve.  In such conditions, modest changes in demand can have a big impact on the price.

A shift of the demand curve shows how much demand would change (at the given price) due to a change in some underlying factor other than price.  Inducing drivers to shift to public transit by ending the charging of fares on transit systems is one such example.  There are others, such as encouraging more work from home (so no commute at all is needed).  And should the economy fall into a recession (which I see as increasingly likely in 2023), there will also be a reduction in fuel demands.  But the latter is not a cause of lower prices that one should hope for.

 

The Great Resignation Has Been Greatly Exaggerated

I would like to acknowledge and thank Mr. Steve Hipple, Economist at the Bureau of Labor Statistics, for his generous assistance in assembling the data used in this post from the public-use micro data files of the Current Population Survey.  This post would not have been possible without his help.

A.  Introduction

There has been much discussion in recent months about workers resigning from their jobs at record high levels.  This has often been attributed to workers reassessing their lives and deciding their jobs are simply not worth it.  A new name has even been coined for this:  the “Great Resignation”.

But while resignations have indeed been high, two quite distinct matters have often been confounded.  One is workers resigning from a position in order to move to a new, more attractive and usually higher-paying, position with a different employer.  The other is workers resigning from a position with no intention to take a new job, but rather to leave the labor force and do something else.  The former reflects a reshuffling in the economy, with workers moving to positions where they will likely be better paid and more productive.  This should raise the overall productivity of the economy.  The latter (those leaving the labor force) would reduce the overall capacity of the economy, if significant.  But as we will see below, while quits from jobs in order to move to a new job is, indeed, at record high levels, the number quitting in order to drop out of the labor force is at this point quite modest, and likely also to prove temporary.  While the Covid pandemic led to a major shock in the labor market, previous trends in labor market participation rates are reasserting themselves.

This post will look at the data on each of these two issues – both important but also both quite different.  It will start with the figures on turnover in the labor market, and present these figures in the context of the net number of new jobs being created.  Quits are high, but hiring is also at record highs.  Workers are quitting their jobs largely to switch to more attractive jobs.

While far more modest, some workers have, however, left the labor market.  The second part of this post will look at the reasons given by those not in the labor force for why they are not, and how this has changed from before the pandemic hit.  This is based on original data assembled from the public use micro data files of the Current Population Survey (CPS).  While publicly accessible by scholars and researchers, these figures are not presented in the regular monthly reports of the Bureau of Labor Statistics on the CPS.  This data will hopefully serve to better inform the discussion on what has been termed by some as the “Great Resignation”.

We will see that the changes in the number of US adults deciding whether or not to participate in the labor force are now modest compared to pre-pandemic trends, and are mostly accounted for by older workers deciding to retire earlier than what would have been expected, on average, under previous patterns.  But to the extent some worker decides to retire now, a year or two earlier than when they had earlier planned, there will then be one less worker retiring a year or two from now.  That is, there will not be a long-term impact, and one should expect to see a return to previous trends.  And so far, that is precisely what we have been seeing.

B.  Quits, Job Openings, and Net New Jobs

The number of workers quitting their jobs each month has indeed risen – and to the highest levels of at least two decades (the data do not go back further).  But the number of workers being hired each month to fill open positions has also increased – to even higher levels.  And despite the record pace of hiring, the number of open jobs employers are seeking to fill has grown to especially high levels.

The figures are shown in this chart:

The data come from the Job Openings and Labor Turnover Surveys (JOLTS) of the Bureau of Labor Statistics (BLS), a monthly survey of employers (although with reports that lag one month compared to the more closely watched monthly BLS report titled “The Employment Situation”, with its figures on such estimates as the unemployment rate and on the net number of new jobs in the economy).  The JOLTS surveys are relatively recent, with data going back only to December 2000, in contrast to the CPS, which goes back to 1948.  The chart here is shown in terms of the absolute number of workers or jobs in each group.

[Side Note: One might sometimes see a chart similar to this but shown in terms of rates:  Hires and Quits shown as a percentage share of the number employed, and Job Openings as a percentage share of the number employed plus the number of job openings.  However, for the relatively short period here (21 years) the patterns in the two presentations look very much the same,]

The number of “Hires” are the number of workers added to the payroll in the given month, according to this survey of employers.  Employers are also asked how many workers left the payroll (“Total Separations”) and whether they were workers who left voluntarily (“Quits”), were laid off or discharged involuntarily (“Layoffs & Discharges”), or left for some other reason (“Other Separations”).  The BLS includes in the Other Separations category those who left to go into retirement, or due to a new disability, or due to deaths.  Hence quits are only one reason for workers leaving their jobs, although its share has been growing:  Layoffs & Discharges have been falling, while the number in the “Other Separations” category has been flat and relatively low. (These latter two categories were not included in the chart to reduce the clutter.)

Hires and the various categories of separations are all flows, measured by the BLS over the course of a full month (and then seasonally adjusted, which among other effects will compensate for the different number of days in different months).  The “Job Openings” estimate, in contrast, is a stock, reporting the number of open job positions the employer is actively seeking to fill as of the last business day of each month.  Its scale on the chart therefore should not be taken as directly comparable to the number of Hires or Quits on the chart, which are flows over the course of a one-month period.  While they happen to be similar in number, one could have reported the number of Hires or Quits over, say, a two-month period (in which case they would have been about twice as much).  One needs to remember that stocks and flows are different.

As the chart shows, open jobs that employers are seeking to fill (“Job Openings”) have grown sharply over the last year.  While the monthly rate of hires has also grown – to record levels – the hiring could not keep up.  And with more workers being hired and actively recruited to fill the open job positions, it should not be at all surprising that the number of workers quitting their old jobs to take a new job – a job that is more attractive to them that probably also pays more –  has also been increasing.  Thus there are resignations, but not to leave the labor force.  Rather, workers are resigning to switch to a new, more attractive, job.

Such “churn” in the labor market is a good thing.  Not only are workers moving to what is for them a more attractive (and likely higher-paying) job, but the productivity of the economy as a whole will also go up as a result.  Employers are able to pay more to attract the workers to these jobs because the workers hired into those jobs will likely be producing more than they had in their old jobs.

How do we know that the quits were largely in order to move to a new job?  It is clear from the magnitudes.  The number of quits in the JOLTS data from March 2020 through February 2022 totaled over 85 million over the two-year period.  And this does not even include those quitting in order to retire (they are included in the “other” category in JOLTS).  Yet as will be discussed in the next section below, the labor force in February 2022 totaled only about 2.7 million less as of February 2022 than what would have been the case had the pre-pandemic shares of participation in the labor force continued.  And close to three-quarters of that 2.7 million reduction was due to workers entering into retirement at somewhat greater rates than was the pattern before.  This is nowhere close to the 85 million quits over the period.

One can also compare the monthly averages for the labor turnover figures with the net figures for new jobs:

The chart shows the average monthly figures for 2021, all from the BLS (either from JOLTS or the CPS).  January figures are excluded as the BLS changes each January the population controls it receives from the Census Bureau for its CPS figures, without revising earlier estimates.  This can lead to an abrupt one-month change in January, making it not comparable to the changes found in other months.

The first three columns show the average monthly growth in 2021 in the adult population (117,000), in the labor force (192,000), and in the number of net new jobs (547,000).  Over the long term, the labor force cannot grow faster than the adult population, but it did in 2021 as the labor force participation rate rose in 2021 following the turmoil of 2020.  And the net number of new jobs could grow faster in 2021 than the increase in the labor force as the number of unemployed fell rapidly in this first year of the Biden administration.  But the economy is now at full employment, and unemployment will not be able to fall much further.  Thus over the longer-term one cannot expect the net number of new jobs to grow faster than the increase in the labor force, and one cannot expect the labor force to grow faster than the adult population (and indeed normally by substantially less, as not all adults choose to be part of the labor force).

In contrast to the figures seen in the first three columns, the average monthly number of workers hired is far higher.  So is the number of separations, and it is the relatively small difference between the number of workers hired into positions and those separated from them for whatever reason that equals the number of net new jobs in the economy.  The separations in 2021 mostly came from quits (70% of the total), with smaller numbers from layoffs or discharges and from the “other” category (where, as noted before, the BLS includes those choosing to quit due to retirement).

All this is consistent with a very strong labor market.  Workers are indeed resigning, but this is largely due to the opportunity to move to a more attractive, better paying, open job.  As we will discuss in the next section, relatively few are resigning to leave the labor force altogether.

C.  The Extent to Which the Labor Force Fell, and the Factors Behind It

As of February 2022, there were 592,000 fewer US residents in the labor force (in the seasonally adjusted figures) than there were in February 2020, just before the lockdowns due to Covid began.  This is not much:  Just 0.4% of the labor force.  But it is not a fair comparison.  The adult population grew over those two years, and thus one would expect that in normal circumstances, the labor force would also have grown.  The question is by how much.  For this one needs to construct some counter-factual scenario of what the labor force would have been (in normal circumstances) and compare that to what it in fact was (given the consequences of Covid) to see how much of a change there was.  Is there evidence here for a “Great Resignation”, of people leaving the labor force in high numbers?

A simple and reasonable counterfactual would be to assume the labor force (in a breakdown by individual groups based on gender and age) would have grown in the absence of the crisis at the same rate as their population.  Population growth is determined by long-term demographics.  That is, in this scenario it is assumed that the rates at which those in the individual demographic groups chose to be part of the labor force (the labor force participation rate) would have remained the same as what they were in February 2020.  Similarly, the rates of those choosing not to be part of the labor force would be the same as in February 2020 (it will simply be one minus the labor force participation rates), and similarly for the reasons given for not participating in the labor force (e.g. retirement, home or family care, full-time students, disability, and so on).  One can then compare changes in the labor force and in the numbers not in the labor force (by the reasons given for this), under a scenario where the participation rates in February 2022 were the same as they were in February 2020, to what they actually were in February 2022.

The households surveyed in the monthly CPS are asked, when they respond that they are not employed and have not been actively seeking a job, the major reason for why they are not in the labor force.  However, the BLS monthly report on the findings of that month’s CPS survey does not report these reasons.  The monthly report is already pretty long.  However, one can obtain these results from the CPS public-use micro data files on the CPS.  The results reported here come from those files (and were assembled by Mr. Steve Hipple of the BLS for this post).

The basic results for the whole population, and for men and all women separately, are summarized in this chart:

Had the participation rates remained the same as in February 2020, there would have been an extra almost 2.7 million workers in the labor force in February 2022.  The labor force would have been 1.6% higher than what it was.  While significant, I would not see this as qualifying as a “Great Resignation”.

[Technical note:  The calculations for those in the labor force and those not in the labor force (by reason) were worked out first for the most basic groups examined:  men and women, each in three different age groups of ages 16 to 24, 25 to 54, and 55 and above, for a total of six groups.  The aggregations for all men or all women, for both men and women in each age group, and for everyone together, were then calculated by summing over the relevant groups.]

Almost three-quarters of the 2.7 million reduction (2.0 million, or 73% of the total) reflected a higher share of adults choosing to retire.  This is consistent with the story that with the disruption in the last two years, coupled also with significant income supplements being provided to most households through the various Covid relief measures passed by Congress during the administrations of both Trump and Biden, a significant number of workers decided to retire earlier than they had previously planned.  It might be a year or two earlier, or possibly longer.  The implications of this are important, as it implies that the changes in the labor force will be temporary rather than permanent.  One more person retiring now, earlier than they had previously planned, means there will be one less person retiring at whatever that future date was to have been.

The second most important reason for leaving the labor force was to take care of home or family, with this accounting for 582,000 workers – 22% of the total reduction in the labor force in the scenario being examined.  This is also understandable in the context of the Covid crisis.  Many workers had to leave the labor force during the midst of the crisis to take care of school-age children when the schools were closed, but almost all schools are now once again open (albeit with some occasional disruption due to Covid outbreaks).  There might also have been a need to take care of family members who became sick during the crisis with Covid itself, and that might still have been a factor in February 2022 (as the Omicron wave subsided).  To the extent this has been Covid driven, these effects should also prove to be temporary as the Covid crisis recedes.

There are, in addition, a list of other possible reasons given in the CPS survey for not participating in the labor force (such as full-time studies as a student, disability, illness, and a catch-all “other” category).  In the aggregate the difference these made in the scenario being examined was small:  only 138,000 – or only 5% of the total reduction in the labor force in this scenario.

In terms of the gender breakdown, more women than men left the labor force in the given scenario (1.7 million women vs. 1.0 million men) even though the share of the labor force made up of women (47% in 2022) is less than the share made up of men (53%).  The shares of this due to more entering retirement or for taking care of home or family are broadly similar between men and women, which is perhaps surprising.  Indeed, the share reporting that they are not in the labor force due to home or family care was somewhat higher for men (25.2% of their total) than for women (19.4%), but it is not clear whether such differences should be considered significant.  The underlying data comes from surveys, there will be statistical noise, and these figures are all based on changes between what the February 2022 levels were and what they would have been in a scenario where we assume the February 2020 participation patterns had remained.

The figures broken down by age group were:

The largest single cause leading to lower participation in the labor force (in the scenario where prior patterns would have remained) was an increase in the share of retirees among those aged 55 and above.  This accounted for 1.5 million workers, which was 3.9% of adults in this age group.  Surprisingly (at least to me) was that there was essentially no difference in this age group of those who were not in the labor force due to home or family care.

Among prime-age workers (ages 25 to 54) there were roughly similar shares among those no longer in the labor force who gave as their reason retirement or for home or family care.  The total number no longer in the labor force (relative to the scenario being examined) was also relatively small for this 25 to 54 age group, at just 0.9% of the population in the age group.  The share no longer in the labor force in the group aged 55 and above was substantially higher, at 3.1% of the population of that age group.  This is as one would expect when the primary factor behind those leaving the labor force was early retirement.

The share of the youngest age group (ages 16 to 24) no longer in the labor force fell by 2.6%, but primarily here for reasons lumped into the “all other” category.  The largest single factor here was full-time studies, but this accounted for just 144,000 of the 414,000 (about 35%) in this “all other” category.  One should also note that while there is a small number in the “retired” category (19,000), this is probably just a reflection of the fact this is a survey.  Respondents do not always fully understand the nature of the questions or may have been in some unusual circumstance that does not fit in well with any of the listed possible responses.

Graphically, how much of a difference has it made?  Not much.  In terms of the labor force participation rates, one has for men and for women, as well as overall:

And by age group, as well as overall:

The “X” on each category shows where the labor force participation rates would be had the February 2020 rates (for the underlying groups of men or women by each age group) continued to hold.  There was certainly a large shock to the system at the start of the pandemic, with the lockdowns that suddenly became necessary in March 2020.  There was then a partial bounceback, followed by a leveling off but with a continued but slow recovery to the earlier patterns of participation rates.  While still not fully back to what they were, the difference is now relatively modest.

This return to previous patterns in the participation rates is likely also to continue.  With the single most important factor (almost three-quarters of the total) being people retiring earlier than what they had planned (or to be more precise, earlier than in the observed pattern in prior years, before the pandemic), the labor force numbers should be expected to return to their previous path in a few years.  As noted before, if some worker retires a year or two earlier than they had earlier planned, then there will be one less retirement in a year or two (as that worker is already retired).  This is consistent with the observed slow return to previous labor force participation rates.

D.  Conclusion

The number of workers quitting their jobs has been high.  But the quits are not a reflection of workers dropping out of the labor force.  Rather, quits have been high as workers quit one job to move to another job – more attractive and likely better paying.  Hires have also been exceptionally high.  And despite the high rate of hiring, employers could not keep up and the number of open jobs they have been seeking to fill has grown.  While some workers have left the labor force during the disruptions of the Covid pandemic, about three-quarters of this (as of February 2022) stemmed from a somewhat higher share of workers choosing to retire.  But unless there has been a permanent change in retirement patterns (and there is no indication that there has been), decisions during the pandemic to retire earlier than previously planned will be self-correcting.

The high level of quits reflects, rather, an extremely strong labor market.  Indeed, the number of net new jobs created in 2021, the first year of the Biden administration, came to 6.7 million – the highest in any one year in US history.  (To be fair one should also note that the fall in the number of jobs in the US in 2020, the last year of the Trump administration, was also the highest in US history.  Thus the Biden record was made possible by the low starting point.)  With this strong labor market, workers have more of an opportunity to move to jobs that can make better use of their talents.  And they have taken advantage of this opportunity, which will be a boost both to the workers and to productivity in the economy as a whole.

It is Time to Admit the Purple Line Was a Mistake

The Path the Purple Line Will Take – Before and The View At Rock Creek Now

A.  Introduction

The proposed Purple Line, a 16-mile light-rail line passing in an arc across parts of suburban Maryland around Washington, DC, has become a fiasco.  The State of Maryland, under Republican Governor Larry Hogan, is preparing to sign a new contract with the private concessionaire that will pay that concessionaire $3.7 billion more than had been agreed to under the existing contract.  The total cost of that contract alone (there are significant other costs on top) will now be $9.3 billion (66% more than the $5.6 billion set in the earlier contract), and the opening will be delayed by at least a further 4 1/2 years (thus doubling the originally contracted construction period – now to a total of 9 years).  And the governor is doing this with no legislative approval being sought.

The Purple Line has long been controversial – due to its high cost, the disruption it is causing to a number of suburban neighborhoods, the destruction of parkland it has been routed through, and its use of scarce resources for public transit to benefit a privileged few rather than the broader community.  There are alternatives that would not only be far more cost-efficient but also less environmentally destructive.  The project illustrates well why the US has such poor public transit and poor public infrastructure more generally, as scarce resources are channeled into politically-driven white elephant projects such as this.

In response to the announcement of the terms of the revised contract with the concessionaire, I submitted to the Washington Post a short column for its “Local Opinions” section.  They have, however, declined to publish it.  This is not terribly surprising, as the Washington Post Editorial Board has long been a strong proponent of the Purple Line, with numerous editorials pushing strongly for it to go forward.  And while the Post claims that it supports an active debate on such issues, the guest opinion columns it has published, as well as letters-to-the-editor, have been very heavily weighted in number to those with a similar view as that of its Editorial Board.

I am therefore posting that column here.  It has been slightly edited to reflect developments since it was first drafted, but has been kept in style to that of an opinion column.

Opinion columns must also be short, with the Post setting a tight word limit.  That means important related issues can not be addressed due to the limited space.  But with room here, I can address several of them below.  Finally, I will discuss the calculations behind two of the statements made in the column, as a “fact check” backing up the assertions made.  These should themselves be of interest to those interested in the Purple Line project (and in public transit more broadly), as they illustrate factors that should be taken into account when assessing a project such as this.

B.  The Column Submitted to the Washington Post

This is the column submitted to the Post, with some minor changes to reflect developments since it was first drafted:

               It is Time to Admit the Purple Line was a Mistake

Governor Hogan has re-negotiated the contract with the private concessionaire that will build and operate the 16-mile long Purple Line through suburban Maryland.  The Board of Public Works has approved it, and despite an extra $3.7 billion that will be spent the Maryland legislature will have no vote.  The private concessionaire will now be paid $9.3 billion, a 66% increase over the $5.6 billion cost in the original contract.  And this is just for the contract with the concessionaire.  The total cost, including contracts with others (such as for design and engineering work) as well as direct costs at the Maryland Department of Transportation (MDOT), is likely well over $10 billion.

The amount to be paid to the concessionaire for the construction alone will rise to $3.4 billion from the earlier $2.0 billion, an increase of 70%.  And even though the construction is purportedly halfway complete (with $1.1 billion already spent), the remaining amount ($2.3 billion) is larger than the original total was supposed to be.  And the amount being paid to the private contractors for the construction will in fact be even higher, at $3.9 billion, once one includes the $219 million MDOT has paid directly to the subcontractors in the period since the primary construction contractor withdrew, and the $250 million paid to that primary contractor in settlement for the additional construction expenses it incurred.  That $3.9 billion is close to double the $2.0 billion provided for in the original contract.  In addition, the project under the new contract will require an extra 4 1/2 years (at least) before it is operational, doubling the time set in the original contract to 9 years.  Even though the project is purportedly halfway built, the remaining time required will equal the time that was supposed to have been required under the original plan for the entire project.

The critics were right.  They said it would cost more and take longer than what Maryland asserted (and with supposedly no risk to the state due to the “innovative” contract).  It also shows that it is silly to blame the opponents of the project.  The lawsuit delayed the start of construction by less than 9 months.  That cannot account for a delay of 4 1/2 years.  Furthermore, the state had the opportunity during those 9 months to better prepare the project, acquire the land required, and finalize the engineering and design work.  Construction should then have been able to proceed more smoothly.  It did not.  It also shows that Judge Leon was right when he ruled that the project had not met the legal requirements for being adequately prepared.

Even the state’s own assessment recognized that such a rail line was marginal at best at the costs originally forecast.  With the now far higher costs, no unbiased observer can deny that the project is a bad use of funds.  The only possible question is whether, with what has already been spent, the state should push on.  But so far only $1.1 billion has been spent on the construction, plus the state agreed to pay the former construction company the extra $250 million when it quit the project.  Thus close to $8 billion (plus what the state is spending outside of the contract with the concessionaire) would be saved by stopping now.

There are far better uses for those funds.  A top priority should be to support public transit in Montgomery and Prince George’s countries.  Even at the originally contracted cost for the Purple Line there would have been sufficient funds not only to double capacity on the county-run bus systems (doubling the routes or doubling the frequency on the routes or some combination), but also to end charging any fares on those buses.  Those bus systems also cover the entire counties, not simply a narrow 16-mile long corridor serving some of the richest zip codes in the nation.  In particular, better service could be provided to the southern half of Prince George’s, the location of some of the poorer communities in the DC area and where an end to bus fares would be of particular benefit.

Covid-19 has also now shown the foolishness of spending such sums on new fixed rail lines.  DC area Metro ridership is still 80% below where it was in 2019.   Rail lines are inflexible and cannot be moved, and in its contract the state will pay the concessionaire the same even if no riders show up.  Who knows what will happen to ridership in the 35 years of this contract?  In contrast, bus routes and frequency of service have the flexibility to be adjusted based on whatever develops.

It is time to cut our losses.  Acknowledge it was a mistake, don’t sign the revised contract, and use the funds saved to provide decent public transit services to all of our residents.

C.  Additional issues

a)  The Cost of Not Keeping the Original Construction Contractor

Media coverage of the proposed new contract has focussed on the overall $9.3 billion cost (understandably), as well as the cost of the construction portion alone.  The figure used for that construction cost has been $3.4 billion, a 70% increase over the originally contracted $2.0 billion cost.

But as noted in the column I drafted above, that $3.4 billion excludes what MDOT has paid directly to the subcontractors who have continued to work on the project since September 2020 (under the direct supervision of MDOT) after the original primary contractor (Fluor, a global corporation with projects on six continents) exited.  According to a report by MDOT in January 2022, $219 million was paid directly by MDOT for this work, and this will be in addition to the $3.4 billion to be paid to the concessionaire.  One should also add in the $250 million Maryland has agreed to pay the original primary contractor in the settlement for its claims that it incurred an additional $800 million in construction expenses on the project – expenses that were the fault of the state from an inadequately prepared project.  That $250 million was for construction costs incurred, and should be included as part of the overall construction costs that MDOT is paying the concessionaire.  The total to be paid for the construction (if there are no further cost increases, which based on the experience so far cannot be guaranteed) is thus in fact $3.9 billion.  This is close to double the original contracted cost of $2.0 billion.

This also raises another issue, which remarkably does not appear to have been discussed (from all that I have read).  The original contractor in 2020 had requested an additional $800 million in compensation for extra costs incurred in the project that it argued were the fault of the state.  One can debate whether this was warranted and whether it was the fault of the state or the contractor, but the amount claimed was $800 million.  Thus, had the state agreed, the total cost would then have been $2.8 billion, up from the originally contracted $2.0 billion.  The state rejected this, however, and then congratulated itself for bargaining the $800 million down to “only” $250 million.

But now we see that the overall amount to be paid the private firms building the rail line will be $3.9 billion.  Fluor was evidently right (even conservative) in its claim that building the project will cost more.  But the $3.9 billion it will now cost is $1.1 billion more than the $2.8 billion they would have paid had the state agreed to cover the $800 million (which probably could have been bargained down some as well).  This hardly looks like smart negotiating by Governor Hogan and his state officials.

Put another way, state officials refused to pay an extra $800 million for the project, insisting that that cost was too high.  They then negotiated a contract where instead of paying $800 million more they will pay $1.9 billion more – for the same work.  And then they sought praise for negotiating a new agreement where they will pay “only” an extra $1.9 billion.

Furthermore, the re-negotiated contract will not only pay $1.9 billion more for the construction, but also higher amounts for the subsequent 30 years when the concessionaire will operate and maintain the line.  Maryland had agreed to pay a total of $2.3 billion for this over the 30 years in the original 2016 contract, but in the re-negotiated contract will now pay $2.6 billion, an increase of $300 million.  Governor Hogan had earlier asserted that under its “innovative” PPP contract, the state would not have to cover any cost increases for the rail line operations over those 30 years – but now it does.  In addition, due to the now far higher construction costs and the proportionately much higher share of those costs that will be funded by borrowing (as the up-front grants to be provided will be largely the same – $1.36 billion will now be provided, vs. $1.25 billion before), the total financing costs over the life of the contract will now be $2.8 billion versus $1.3 billion before, an increase of $1.5 billion.  Thus the total contract will now cost $9.3 billion versus $5.6 billion before, an increase of $3.7 billion (which equals the $1.9 billion on construction + $0.3 billion on operations + $1.5 billion on financing).

It is difficult to see how there is any way this can be interpreted as smart negotiating.

b)  Don’t Blame the Lawsuit for the Problems

The politicians responsible for the Purple Line, starting with Governor Hogan, blame the lawsuit brought by opponents of the Purple Line for all the problems that followed.  This is simply wrong, and indeed silly.  The ruling by Judge Richard Leon delayed the start of construction by less than 9 months.  This cannot account for a delay that will now be at least 4 1/2 years (assuming no further delays).  Nor can it account for a project cost that is now $3.7 billion higher.

Judge Leon ruled in August 2016 that the State of Maryland had not fulfilled the legal conditions required for a properly prepared project.  The primary issue was whether a project such as this, with the unavoidable harm to the environment that a new rail line will have, is necessary to provide the transit services needed in the corridor.  Could there be other options that would provide the services desired with less harm to the environment?  If so, the law requires that they be considered.  The answer depends critically on the level of ridership that should be expected, and the State of Maryland argued that only a rail line would be able to handle the high ridership load they forecast.  Many of the Purple Line riders would be transferring from and to the DC Metrorail lines it would intersect, and the State of Maryland claimed that the DC Metrorail system (just Metro, for short) would see a steady rise in ridership over the years and thus serve as a primary draw for Purple Line riders.

Judge Leon observed that in fact Metro ridership had been declining in the years leading up this case (2016), and ruled that Maryland should look at this issue and determine whether, based on what was then known, a less environmentally destructive alternative to the Purple Line might in fact be possible.  If Maryland had complied with this ruling, they could have undertaken such a study and completed it within just a few months.  There would have been little surprise if such a study, under their own control, would have concluded that the Purple Line was still warranted.  The judge would have accepted this, and they could then have proceeded, with little to no delay.  Construction had only been scheduled to begin in October 2016.

Instead, the State filed numerous motions to reverse the ruling and to be allowed to proceed with no examination of their ridership assumptions.  They argued in those motions that there would be a steady rise in Metro ridership over time, and that by the year the Purple Line would open (then expected to be in 2022) Metro ridership would have been growing at a steady pace for years, which would then continue thereafter.  When Judge Leon declined to reverse his ruling, the State appealed and then won at the Appeals Court level.  The judges in the Appeals Court decided that the judicial branch should defer to the executive branch on this issue.  Construction then began in August 2017.  The Purple Line contractors said that they were delayed by 266 days ( = 8.7 months) as a result of Judge Leon’s ruling.

We now know that Judge Leon was in fact right in raising this concern with the prospects for Metro ridership.  Ridership on the system had in fact been falling for a number of years leading up to 2016, and it has continued to fall since then.  Metro ridership peaked in 2008, fell more or less steadily through 2016, and then continued to fall.  Ridership in 2016 was 14% below where it had reached in 2008 (despite the Silver Line opening with four new stations in 2015), and then was even less than 2016 levels in 2019.  And all this was pre-Covid.  Metrorail ridership then completely collapsed with the onset of Covid, with ridership in 2020 at 72% below where it was in 2019 and in 2021 at 79% below where it was in 2019.

Judge Leon was right.  Even setting aside the collapse in ridership with the onset of Covid, Metro ridership declined significantly and more or less steadily for more than a decade.  It was not safe to assume (as the state insisted in its court filings would be safe to assume) that Metro ridership would resume its pre-2008 upward climb.  And now we have seen not only the collapse in Metro ridership following from Covid, but also the near certainty that it will never fully recover due to the work-from-home arrangements that became common during the Covid crisis and are now expected to continue at some level.

In addition and importantly, while the Purple Line contractor noted that the judicial ruling delayed the start of construction by 266 days, this does not mean project completion should have been delayed by as much.  As Maryland state officials themselves noted, while the ruling meant construction could not start, the state could (and did) continue with necessary preparatory work, including final design work, acquisition of land parcels that would be needed along the right of way, and the securing of the necessary clearances and permits that are required for any construction project.  The state was responsible for each of these.  With the extra 9 months they should have been able to make good progress on each, and with this then ensure that the project could proceed smoothly and indeed at a faster pace once they began.

This turned out not to be the case.  Despite the extra 9 months to prepare, the Purple Line contractors cited each of these as major problems causing delays and higher costs.  Final designs were not ready on time or there had to be redesigns (as for a crash wall that has to be built for the portion of the Purple Line that will run parallel to CSX train tracks); state permits were delayed and/or required significant new expenditures (such as for the handling of water run-off); and the state was late in acquiring “nearly every” right of way land parcel required (there were more than 600) – and “by more than two years in some cases”.

An extra 9 months for preparation should have led to fewer such issues.  That they still were there, despite the extra 9 months, makes one wonder what the conditions would have been had they started construction 9 months earlier.  The extra time to prepare the project – where these were later revealed still to be major problems – likely saved the project money compared to what would have been the case had they started construction earlier.  It simply makes no sense now to blame that extra 9 months for the difficulties when they in fact had an extra 9 months to work on them.

c)  Diversion of MARC Revenues to Get Around Maryland’s Public Debt Limits

Under the Purple Line contract, the State of Maryland will be obliged to pay the concessionaire certain set amounts over 35 years, starting with a payment of $100 million when operations start (in a planned 4 1/2 years from now), but especially then for the following 30 years when the concessionaire will operate the line.  The state will be obliged to make those payments for those 30 years on the sole condition that the rail line is available to be operated (i.e. is in working order).  Hence those payments are called “availability payments”.  The payments will be the same regardless of ridership levels.  Indeed, they will have to be made (and in the same amount) even if no riders show up.  A major share of the availability payments will be made up of what will be required to cover the principal and interest on the loans that the concessionaire will be taking out to finance the construction of the project, with the repayment then by the state through the availability payments.  The concessionaire is in essence borrowing on behalf of the state, and the loans will then be repaid by the state via the concessionaire.

These long-term budget obligations are similar to the obligations incurred when the state borrows funds via a bond being issued.  Indeed, this can hardly be disputed for the borrowing being done by the concessionaire to finance the construction, with the state then repaying this through the availability payments.  it is also, at 35 years, a longer-term financial obligation than any bond Maryland has ever issued.  Governor Hogan will be tying the hands of future governors for a very long time, as failure to repay on the terms he negotiated would be an event of default.

Due to concerns of excessive government borrowing undermining finances, many states have set limits on the amount they can borrow.  In Maryland, the state has set two “capital debt affordability ratios”, which limit outstanding, tax-supported, state debt to less than 4% of Maryland personal income and the debt service that will be due on this debt to less than 8% of state tax and other revenues.

If the 35-year long Purple Line obligations were treated as state debt, then there could be a problem of Maryland running close to, and possibly exceeding, these debt affordability ratios.  This is discussed in further detail in an annex at the end of this blog post, with illustrative calculations.  Exceeding those limits would be a significant issue for the state, and might conceivably put it in violation of conditions written into the contracts for its outstanding state bonds.  To avoid this, or even if the Purple Line obligations would bring it closer to but not over those limits, Maryland would need to limit its public sector borrowing, postponing other projects and programs due to the limited borrowing space that the Purple Line has used up.

The issue is not new.  It already arose in the contract signed in 2016.  But it will be even more important now due to the higher cost of the concession  – $9.3 billion to be paid to the concessionaire vs. $5.6 billion before.

Lawyers can debate whether the payment obligations (or a portion of them, e.g. the portion directly tied to the debt incurred by the concessionaire on behalf of the state) should or should not be included in the state’s capital debt affordability ratios.  But to forestall such a debate, MDOT has chosen to create a special trust account from which all payments for the Purple Line would be made.  That trust would be funded by Purple Line fare revenues (whatever they are) and grant funds received for the project (primarily from federal sources).  But MDOT acknowledges that such funding would not suffice for the financial obligations being incurred for the Purple Line, at least for some time.  And if direct support to cover this was then provided from the Maryland state budget, where revenues come primarily from taxes, the Purple Line obligations would be seen as tax-supported debt and hence subject to the borrowing limits set by the capital debt affordability ratios.

So instead of openly providing funding directly from the state budget, they will channel fare revenues collected on MARC (the state-owned commuter rail system) in the amounts necessary to cover the payment obligations on the Purple Line.  But MARC does not run a surplus.  Like other commuter rail lines it runs a deficit.  Each dollar in MARC fares channeled to cover Purple Line payment obligations thus will increase that MARC deficit by a dollar.  But then, for reasons that make little sense to an economist but which a lawyer might appreciate, those higher MARC deficits can be covered by increased funding from the state budget without this impacting the state’s capital affordability limits.  The identical payments if sent directly to cover the Purple Line obligations, however, would be counted against those ratios.

But this is just a shell game.  The funding to cover the Purple Line payment obligations are ultimately coming from the state budget, and routing it via MARC transfers simply serves to allow the state to bypass the capital debt affordability limits.  It also reduces transparency on how the Purple Line costs are being covered.

Nor are the agencies that assign ratings to Maryland state bonds being fooled by this.  S&P, for example, noted specifically that it will take into account the payment obligations on the Purple Line when they compute for themselves what the capital debt affordability ratios in fact are.

d)  Role (or Lack of It) of the State Legislature

Under the new contract Governor Hogan and his administration have negotiated, a total of $9.3 billion will be paid to the concessionaire, or $3.7 billion more than the $5.6 billion that was to be paid under the original contract.  The state legislature will apparently have no say in this.  While it will bind future administrations to make specified payments over a 35 year period, with payments that must be made regardless of ridership or any factor the state has control over (the rail line needs merely to be “available”), the only recognized check on this is apparently a vote in the Board of Public Works.  But there are only three members on this Board, only two votes are required for approval, and the governor has one of those two votes.  The legislature has no role.

I find this astonishing.  The state legislature is supposed to set the budget, but no vote will be taken on whether the further $3.7 billion should be spent.  Indeed, it appears the legislature would have no role regardless of how much the current governor is binding his successors to pay (Governor Hogan will be long out of office when the payments are due), nor for how long.  Suppose it was twice as much, or ten times as much, or whatever.  And while this commitment will be for 35 years to 2056 (five years past what was in the original contract), it appears the same would apply if the revised contract were extended to 50 years, or 100 years, or whatever.  Under the current rules, it appears that the legislature has accepted that the governor can commit future administrations to pay whatever he decides and for as long as he decides, with just the approval of the Board of Public Works.

This is apparently a consequence of the state law passed in 2013 establishing the process to be followed for state projects that would be pursued via a Public-Private Partnership (PPP) approach.  The Purple Line is the first state project being pursued on the basis of that 2013 legislation, with the legislature approving also in 2013 the start of the process on the Purple Line.  This legislative approval was provided on the basis of cost estimates provided to it at the time.  MDOT then issued a Request for Qualifications in November 2013 to identify interested bidders, a Request for Proposals in July 2014, and received proposals from four bidders in November and December 2015.  Following review and final negotiations, MDOT announced the winning bidder on March 1, 2016.  Only then did they know what the cost (under that winning bid) would be, and the state legislature was given 30 days to review the draft contract (of close to 900 pages) during which time they could vote not to approve.  But no vote taken would be deemed approval.  Then, with just the approval of the Board of Public Works as well (received in early April 2016), MDOT could sign the contracts on behalf of Maryland.

However, there will be no such review by the legislature of any amendments to that contract.  Amendments apparently require nothing more than the approval of the Board of Public Works, and with that sole approval, the governor is apparently empowered to commit future administrations to pay whatever amount he deems appropriate, for as many years as he deems appropriate.  The increase in the future payment obligations in this case will be $3.7 billion, but apparently it could be any amount whatsoever, with just the approval of the Board of Public Works.

Based on this experience, one would think that the legislature would at a minimum hold public hearings to examine what went wrong with the Purple Line, and what needs to be done to ensure the legislature retains control of the state budget.  The current legislation apparently gives the governor close to a blank check (requiring only the approval of the Board of Public Works) to obligate future administrations to pay whatever amount he sees fit, for as many years as he sees fit.

Central also to any legislative review of a proposed expenditure is whether that expenditure is warranted as a good use of scarce public resources.  One can debate whether the Purple Line was warranted at the initial cost estimates.  As will be discussed below, at those initially forecast costs even the state’s own analysis indicated it was at best marginal (and inferior to alternatives).  But even if warranted at the then forecast costs, it does not mean the project makes sense at any cost.  Based on what we now know will be a far higher cost, no unbiased person can claim that the Purple Line is still (if it ever was ) a good use of public resources.

Yet remarkably, it does not appear that any assessment was done by any office in Maryland government of whether this project is justified at the now much higher costs.  The issue simply did not enter into the discussion – at least in any discussion that has been made public.  Rather, at the Board of Public Works meeting on the project, Governor Hogan praised MDOT staff for continuing to push the project forward despite the problems.  Indeed, the higher the increase in cost for the project, the more difficult it would be to proceed, and hence the more the staff should be commended (in that view) for nevertheless succeeding in pushing the project through.  This is perverse.

Legislative review is supposed to look at such issues and to set overall budget priorities.  Yet under the PPP law passed in 2013, the legislature apparently has no role to review and consider whether an amended expenditure on such a project is a good use of the budget resources available.

D.  Fact Checks

a)  The Lack of Economic Justification for the Purple Line

The column includes the statement:

Even the state’s own assessment recognized that such a rail line was marginal at best at the costs then envisaged.  With the now far higher costs, no unbiased observer can deny that the project is far from justified.

This statement is based on the results of the state’s analysis reported in the Alternatives Analysis / Draft Environmental Impact Statement, released in September 2008.  The Alternatives Analysis looked at seven options to provide improved public transit services in the Purple Line corridor – an upgrading of existing bus services (labeled TSM for Transportation System Management), three bus rapid transit options (low medium, and high), and three light rail options (low, medium, and high).  All would provide improved public transit services in the corridor.  The question is which one would be best.

The summary results from the analysis are provided in Chapter 6, and the primary measure of whether the investment would be worthwhile is the “FTA cost-effectiveness measure” – see tables 6-2 and 6-3.  The Federal Transit Administration (FTA) cost-effectiveness measure is calculated as the ratio of the extra costs of the given option (extra relative to what the costs would be under the TSM option, and with both annualized capital costs and annual operational and maintenance costs), to the extra annual hours of user benefits of that option relative to the TSM option.  That is, it is a ratio of two differences – the difference in costs (relative to TSM) as a ratio to the difference in benefits (again relative to TSM).  Thus it is a ratio of costs to benefits, and a higher number is worse.  Hours of user benefits are an estimate of the number of hours saved by riders if the given transit option is available, where they mark up those hours saved by a notional factor to account for what they say would be a more pleasant ride on a light rail line (which biases the results in favor of a rail line but, as we will see, not by enough even with this).

The FTA issues guidelines classifying projects by their cost-effectiveness ratios.  For FY2008 (the relevant year for the September 2008 Alternatives Analysis), the breakpoints for those costs were (see Table II-2 in Appendix B of the FTA’s FY2008 Annual Report on Funding Recommendations):

High (meaning best) $11.49 and under
Medium-High $11.50 – $14.99
Medium $15.00 – $22.99
Medium-Low $23.00 – $28.99
Low (meaning worst) $29.00 and over

The Alternatives Analysis estimated that the Medium Light Rail Line option would have a cost-effectiveness ratio of $22.82.  This would place it in the Medium category for the FTA cost-effectiveness measures, but just barely.  This was important, as the FTA will very rarely consider for federal grant funding a project in its Medium-Low category, and never in the Low category.

The other two light rail options examined had worse cost-effectiveness ratios ($26.51 and $23.71 for the Low and High options respectively) that would have placed them in FTA’s Medium-Low cost-effectiveness category, and thus highly unlikely to be accepted by the FTA for funding.  Not surprisingly, the Governor of Maryland (O’Malley at the time) selected the Medium Light Rail option as the state’s preferred option, as the other two light rail options would likely have been immediately rejected, while the Medium Light Rail choice would have been within the acceptable limits – although just barely so.  And while in principle they chose the Medium Light Rail option, they then added features (and costs) to it that brought it closer to what had been the High Light Rail Option, while not re-doing the cost-effectiveness analysis.

Maryland should also have considered any of the three Bus Rapid Transit options, as their cost-effectiveness measures were uniformly better than any of the light rail options (with cost-effectiveness ratios of $18.24, $14.01, and $19.34 for the Low, Medium, and High options respectively).  They were better even without the scaling-up of user benefits (by a notional factor for what was claimed would be a more pleasant ride) that biased the results in favor of the light rail options.  And most cost-effective of all would have been a simple upgrading of regular bus services, introducing express lines and other such services where there is a demand.

These were all calculated at the costs as estimated in 2008.  We now know that the costs for the light rail line option chosen will be far higher than what was estimated in 2008.  That cost then was estimated to be $1.2 billion to build the line, and an annual $25.0 million then for operations and maintenance.  Adjusting these figures for general inflation from the prices of 2007 (the prices used for these estimates) to those of December 2021 would raise them by 34%, or to $1.6 billion for the capital cost and $33.5 million for the annual operational and maintenance costs.  But under the new contract, the capital cost will be $3.9 billion, or 2.4 times higher than estimated in 2008 (in end-2021 prices).  Also, the annual operational and maintenance costs (including insurance) in the new contract will be $2.6 billion over 30 years.  This payment will be adjusted for inflation, and the $2.6 billion reflects what it would be at an assumed inflation rate of 2% a year.  One can calculate that at such a 2% inflation rate, the annual payment over the 30 years in the prices of end-2021 would be $58.0 million, or 73% higher than the $33.5 million had been forecast earlier (also at end-2021 prices).

Putting the capital cost in annualized terms in the same way as was done in the Alternatives Analysis report, and adding in the annual operational and maintenance costs, the overall costs under the new contract (with all in end-2021 prices) is 2.3 times higher than what was forecast in 2008, when the Medium Light Rail option was chosen.  To be conservative, I will round this down to just double.  To calculate what the FTA cost-effectiveness measures would have been (had the forecast costs been closer to what the new contract calls for), one also needs ridership forecasts.  While we know that those forecasts are also highly problematic (as discussed in this earlier blog post, they have mathematical impossibilities), for the purposes here I will leave them as they were forecast in the Alternatives Analysis.

Based on this, one can calculate that the FTA cost-effectiveness measure would have jumped to $50.55 had the capital and operating costs been estimated closer to what they now are under the new contract.  This would have put the Purple Line far into the Low category for cost-effectiveness (far above the $29.00 limit), and the FTA would never have approved it for funding.  And at more plausible ridership estimates, the ratio would have been higher still.

b)  For the Cost of the Purple Line, One Could Double Bus Services in Suburban Maryland, and Stop Charging Fares

Resources available for public transit are scarce, and by spending them on the Purple Line they will not be available for other transit uses.  The Purple Line will serve a relatively narrow population – those living along a 16-mile corridor passing through some of the richest zip codes in the country, providing high-end services to a relatively few riders.  The question that should have been examined (but never was) was whether the resources being spent on the Purple Line could have been used in a way that would better serve the broader community.

A specific alternative that should have been considered would have been to use the funds that are being spent on the Purple Line instead to support public transit more broadly in Montgomery and Prince George’s Counties.  What could have been done?  The alternatives can then be compared, and a determination made of which would lead to a greater benefit for the community.  Only with such a comparison can one say whether a proposed project is worthwhile.

Specifically, what could be done if such resources were used instead to support the local, county-run bus services in Montgomery and Prince George’s Counties (Ride-On and The Bus respectively)?  They already carry twice as many riders as what the Purple Line would have carried in the base period examined (according to its optimistic forecasts), had it been in operation then.  As we will see below, with the funds that the State of Maryland will make in the availability payments on the Purple Line (and net of forecast Purple Line fare revenues), one could instead end the collection of all fares on those bus systems and at the same time double the size of those systems (doubling the routes or doubling the frequency on the current routes, or, and most likely, some combination of the two).  With unchanged average bus occupancy, they could thus serve four times the number of riders that the Purple Line is forecast (optimistically, but unrealistically) to carry.

The services would also be provided to the entire counties, not just to those living along the Purple Line’s 16-mile corridor.  Especially important would be service to the southern half of Prince George’s County, where much of its poorer population lives.  The Purple Line will not be anywhere close to this.  Ending the collection of fares would also be of particular value to these riders.

For the comparison to the cost of running the county-run bus systems, I used data on their operating costs, capital costs, and fare revenues from the National Transit Database, which is managed by the Federal Transit Administration of the US Department of Transportation.  The data was downloaded on February 1, 2022.  The data is available through 2020, but I used 2019 figures so as not to be affected by the special circumstances of the Covid-19 pandemic.

The bus system costs in 2019, along with what the Purple Line costs will be, are:

(in millions of $)

County-Run Bus Systems (for 2019):
Operating costs $157.6
10-year average K costs $17.1
  Total costs $174.7
Fares collected $22.0
  Total to double capacity and no fares $196.7
Purple Line:
Annual availability payments $240.0
Less fares collected (forecast) $45.3
  Net Costs $194.7

The two bottom-line figures basically match, at around $195 million.  The net payments that will be made on the Purple Line over its 30-year life would be $194.7 million, based on the announced availability payment averaging $240.0 million per year less forecast average annual fares to be collected.  That average fare forecast is undoubtedly optimistic (as the ridership forecasts are optimistic), and is based on what was provided in 2016 when the original contract was discussed with the legislature.  I have not seen an updated forecast, but MDOT staff stated (at the Board of Public Works meeting on January 26 to discuss and vote on the new contract) that fares would not be changed from what was planned before.

The cost of doubling the size of the county-run bus systems would have been $157.6 million for the operating cost (based on the actual cost in 2019) plus $17.1 million for the capital cost (based on the 10-year annual average between 2010 and 2019, as these expenditures fluctuate a good deal year to year), or a total of $174.7 million.  It is assumed that government will continue to spend what it is spending now to support these bus systems, so the extra funding needed for doubling the systems would be those costs again (for that second half), plus what is received in fare revenues in the system now (the $22.0 million) as fares would no longer be collected.  Thus the net cost would be $196.7 million, very close to the amount that could be covered by what will be provided on a net basis to the Purple Line (and assuming, optimistically, fares averaging $45.3 million a year).

In addition to this, a total of $1.36 billion will be provided in grants to the Purple Line.  At the lower cost of the earlier, 2016, contract, a portion of those grant funds ($1.25 billion before) would have been needed to cover a share of the costs of doubling the capacity of the bus systems and ending the collection of fares.  One could in principle have invested those grant funds and at a reasonable interest rate have generated sufficient funds to close the remaining gap.  But with the now far higher costs of the renegotiated contract, there would be no need for a share of those grant funds for this, and they could instead be used to provide funding for other high-priority transit needs in the region.

E.  Conclusion

The Purple Line has long been a problematic project, and with the now far higher costs in the renegotiated contract with the concessionaire, can only be described as a fiasco.  After rejecting a demand from the contractor to pay $800 million more to complete the construction of the rail line, they will instead now pay $1.9 billion more to a total of $3.9 billion for the construction alone, or close to double the originally negotiated cost of $2.0 billion.  They will also now pay more for the subsequent operation of the line.  It is all a terribly wasteful use of the scarce funds available for public transit, and comes with great environmental harm on top.  Funds that will be spent by the state under this concession contract could have been far better used, and far more equitably used, by supporting the public transit systems that serve the entire counties.

Despite the much higher costs, there does not appear to have been any serious assessment of whether the Purple Line can be justified at these higher costs.  At least there has not been any public discussion of this.  Rather, MDOT staff appear to have been directed to do whatever it takes, and at whatever the cost it turns out to be, to push through the project.  But that is in fundamental contradiction to basic public policy.  A project might be warranted at some low cost, but that does not then mean it is still warranted if it turns out the cost will be far higher.  That needs to be examined, but there is no evidence that there was any such examination here.

We should also now recognize as obvious that forecasts of ridership on fixed rail lines are uncertain.  Ridership on the DC Metro rail lines not only fell, more or less steadily, over the decade leading up to 2019, but then collapsed in 2020 and 2021 due to the Covid crisis.  Ridership in 2021 was almost 80% below what it was in 2019.  And it is highly unlikely that Metrorail ridership will ever recover to its earlier levels, as many of the former commuters on the system will now be working from home for at least part of the workweek.

Despite this, Governor Hogan has adamantly refused to look at alternatives to building a new fixed rail line, with this to be paid for via a 35-year long concession with private investors that will tie his successors to making regular availability payments regardless of whatever ridership turns out to be, and regardless of any other developments that might lead to more urgent priorities for the state’s budget resources.  The issue is not only that the ridership forecasts on the Purple Line are highly problematic, with mathematical impossibilities and other issues.  It is also, and more importantly, that any such ridership forecasts are uncertain.  Just look at what happened with Covid.  It was totally unanticipated but led ridership to collapse almost literally overnight.  And the effects are still with us, almost two years later.

The fundamental failure is the failure to acknowledge that any such forecasts are uncertain, and highly so.  There might be future Covids, and also other future events that we have no ability to foresee or predict.  For precisely this reason, it is important to design systems that are flexible.  A rail line is not.  Once it is built (at great cost), it cannot be moved.  Bus routes, in contrast can be shifted when this might be warranted, as can the frequency of services on the routes.

None of this seems to have mattered in the decisions now being taken.  As a consequence, and despite billions of dollars being spent, we do not have the transit systems that provide the services our residents need.

 

 

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Annex:  Details on the Diversion of MARC Revenues to Get Around Maryland’s Public Debt Limits

The State of Maryland follows a policy to limit its public borrowing so that state debt does not become excessive.  Specifically, it has set two “capital debt affordability ratios”:

1) Keep the stock of tax-supported state debt below 4% of personal income in the state;

and 2)  Keep debt service on tax-supported state debt below 8% of state revenues.

I am not sure whether these are limits have been set by statute, but as policy they will in any case be reflected in the state bond ratings.  It is also possible that representations, and perhaps even covenants, have been made in the Maryland state bond contracts stating the intention of the state to keep to them.  If so, then violation of those limits could have consequences for those bonds, possibly putting the state technically in default.

The commitments Governor Hogan will be making in signing the concession contracts for the Purple Line are in essence the same as commitments made when the state issues a bond and agrees to pay amortization and interest on that bond as those payments come due.  For the Purple Line, the private concessionaire will similarly be borrowing funds, but the State of Maryland will then have the obligation under the contract to repay that borrowing through the availability payments to be paid to the concessionaire for 30 years.  In addition to repaying (with interest) the borrowings made by the concessionaire, the availability payments will also cover the operational, maintenance, and similar costs over the 30-year life of the contract during which the concessionaire will operate the line.

Under the original contract, signed in 2016, these payments were expected to average $154 million per year for 30 years.  Under the new contract, they are expected to average $240 million a year.  One can debate whether all of the availability payment (which includes payment for the operations and maintenance) or simply some share of these payments should be considered similar to debt, but the payment obligation is fundamentally the same.  Governor Hogan is committing future governors (up until 2056) to make these payments, with the sole condition that the concessionaire has ensured the rail line is available to be used (hence the label “availability payments”).  In particular, they will be obliged to make these payments regardless of what ridership turns out to be, or indeed whether any riders show up at all.  That risk is being taken on fully by the state and is not a concern of the concessionaire (who, indeed, will find things easier and hence preferable the fewer the number of riders who show up).

These availability payments have all the characteristics of a debt obligation.  But if it were treated as state debt, it would have to be included in the capital debt affordability limits, and this could affect the amount that the state could borrow for other purposes.  One can debate precisely what obligations to include and the timing of when they should be included, but purely for the sake of illustration, let’s use the 2016 contract amounts and assume that the obligation to be repaid would have had a capital value of $2.0 billion (equal to the then planned construction cost, minus grants received for it, but plus the present discounted value of non-debt operating and other costs that have been obligated).  Assume also this would have applied in 2017.  Based on figures in the November 2021 report of Maryland’s Capital Debt Affordability Committee (see Table 1 on page 26), the ratio of tax-supported state debt to Maryland personal income was 3.5% in 2017, or below the 4% limit.  However, if the full $2.0 billion from the Purple Line would have been added in 2017, following the contract signing in 2016, that ratio would have grown to 4.1%.

Similarly, the Capital Debt Affordability Committee report indicates (Table 2A on page 28) that debt service on tax-supported public debt in 2017 was 7.5% of state revenues.  If one were to add the full annual $154 million payment that would be due (under the original contract) for the Purple Line already in 2017 (too early, as it would not be due until construction is over, but this is just for illustration), the debt service ratio to state revenues would have risen from 7.5% without the Purple Line commitments to 8.2% with it – above the 8.0% limit.  Of the $154 million, about two-thirds would have been used to repay the funds borrowed to pay for the construction (plus for the equity, which was a small share of the total).  If one argued that only these payments on the debt incurred (and the similar equity cost) should be included, and not also the 30-year commitment to cover the operational and similar other costs, then the ratio would have risen to 7.98% if it applied in 2017 – basically at the 8.0% limit.

Again, these figures are simply for illustration, and the actual additions in 2017 would have been less and/or applied only in later years.  But as a rough indication, they indicate that the Purple Line debt and payments due would be materially significant and hence problematic.

it was thus important that MDOT structure these payment obligations in such a way that it could argue that they are not for “tax-supported public debt”.  This would be the case, for example, if the fare revenues from ridership on the Purple Line would suffice to cover the debt service and other payment obligations incurred.  But even MDOT had to concede the Purple Line revenues would not suffice for that in at least the early years, although it did assert (unconvincingly) that ultimately they would.

MDOT therefore established a separately managed trust for the Purple Line, which would be used to make the payments due and into which it would direct not simply Purple Line fare revenues and grants to be received for the project (primarily from federal sources), but also sufficient revenues from the MARC commuter rail line (operated by MDOT) to make the payments.  It argued also that only the debt service component of the availability payment would have to be included (about two-thirds of the total payment obligation in the 2016 contract), with the operations, maintenance, and other such costs not relevant to the capital debt affordability ratios (despite being a long-term, 30-year, commitment).  The State Treasurer, Nancy Kopp in 2016, ruled that this structure was acceptable and that Purple Line debt should thus not count against the state’s capital debt affordability limits.

But while deemed not applicable for the capital debt affordability limits, the immediate question that arises is what then happens to MARC?  Commuter rail lines in the US do not run a surplus, and require subsidies from a government budget to remain in operation.  MARC is no exception.  If a portion of MARC revenues are diverted to cover payments on Purple Line debt, then MARC’s deficit will rise by that amount and Maryland’s subsidies to MARC will have to rise by that same amount.  And those subsidies will come from state tax revenues.  Hence state tax revenues are in reality covering the Purple Line debt payments, and routing it via MARC does not change that reality.  At a minimum, transparency is being lost.

Furthermore, and as noted before, the state bond rating agencies have made it known that they are fully aware of what is going on, and will include these Purple Line obligations into their calculations.  S&P explained in May 2016 that upon the signing of the Purple Line contract, they will include the net present value of the payments to be made by the state during the construction period in their calculations of the state’s tax-supported debt ratios, and that once operations begin will include in the ratios the full availability payments net of fare revenues collected on the Purple Line only.

Maryland’s payment commitments under the revised Purple Line contract are now expected to average $240 million a year, far above the $154 million expected before.  MDOT has once again made its case with the new State Treasurer (Dereck Davis, who took office on December 17, 2021, replacing the long-time former Treasurer Kopp) that these long-term payment obligations should not count against the state’s Capital Debt Affordability Ratios.  While I have not seen a formal ruling on this from the State Treasurer’s office, presumably he agreed with the MDOT view as otherwise it would not have been presented to the Board of Public Works on January 26.