Want lower gas prices? Cut the U.S. budget deficit

By Money Matters Editors

Americans do a lot of complaining about the price of gasoline. What’s one good way to lower gas prices? Cut the U.S. budget deficit! You read correctly - cut the budget deficit. Here’s why:

Oil has many roles in our modern world. It is, as everyone knows, the primary fuel for transportation in the developed and now in the developing world, too. In the United States, it’s clearly the most important commodity, given the nation’s enormous gasoline use, and consider this staggering statistic: one of every 10 barrels of oil in the world is used to make gasoline for U.S. motorists. Astounding. Talk about a car culture.

But what many motorists – and some investors – do not know is that oil has other roles in the modern world, namely as an asset for investment, hedge, and related funds. Further, some investors buy oil as an inflation hedge. And it’s those two, latter roles, as an asset and as an inflation hedge, that explain the connection between the U.S. budget deficit and price of gasoline in the U.S.

The deficit / oil connection

Oil is priced in dollars. Hence, when the dollar weakens, the price of oil rises: investors bid-up the price of a barrel of oil as a way to protect the purchasing power of that oil. It works like this, ‘A dollar is worth less, so I have to raise the price of my dollar-denominated goods  in order to protect my purchasing power associated with that good.’ Oil closed Wednesday up $3.90 to $70.61 per barrel.

The reverse is also true: as the dollar strengthens, it exerts a downward pressure on the price of oil. But, as investors know, lately the dollar has not been rising. Basically, the dollar has been weakening for the past decade, and the reason is? You guessed it: the enormous U.S. budget deficit.

Sector analysts’ estimates vary, depending on the model they use, but roughly 10-25 percent of the current price of oil is solely due to the U.S. budget deficit, which in the current fiscal year, fiscal 2010, will exceed $700 billion, according to the Congressional Budget Office, and may approach $1 trillion, if the U.S. economic recovery does not take hold. (The U.S. budget deficit for fiscal 2009, which ended September 30, is expected to total $1.28 trillion.)

In other words, $7-18 of the current price of oil can be attributed to the budget deficit and the weak dollar it has created. Assuming a roughly 2.5 cents increase in the price of a gallon of gasoline for every $1 increase in oil, that translates to 17-40 cents more per gallon at the gas pump. Think of that extra 17-40 cents as an extra tax you pay on gasoline, solely due to the budget deficit.

Of course, many other factors affect the price of gasoline (gasoline supply/demand, refiners’ capacity, environmental regulations requiring reformulated gasoline, geopolitical risks that threaten oil production, emerging market demand for oil, speculation, etc.) but the link between the dollar (and hence the U.S. budget deficit) is beyond dispute.

And, the budget deficit/oil price connection is underscored here because, unlike OPEC and other factors, the budget deficit is a factor that Americans can control.

So onto the many other reasons for cutting the deficit (fiscal responsibility, remaining an attractive place for investment capital, lowering interest payment costs, reducing the debt burden on future generations, keeping interest rates low) add another: it will lower the price of gasoline.