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The Economic Consequences of Rising Oil Prices

University of California, San Diego economics professor James D. Hamilton filed this guest blog post:

This morning, the Joint Economic Committee of the U.S. Congress took up the implications of rising world oil demand for the U.S. economy. I was invited to participate along with Daniel Yergin, Co-Founder and Chairman of Cambridge Energy Research Associates.

We have seen a number of episodes over the last half century in which the price of oil shot up dramatically, and each time it was followed by an economic recession. I'm persuaded that the oil price surge over 2007-08 was also an important factor that contributed to the economic recession that began in 2007:Q4.

My testimony focuses on the causes and economic consequences of the big run-up in oil prices that we saw in 2007-08. There was a modest drop in global petroleum production between 2005 and 2008, caused in part by declining production from mature fields in the North Sea and Mexico and a big drop in Saudi Arabian oil production. But despite stagnant production, world petroleum demand continued to boom. World GDP increased by 10.1 percent over these two years, and Chinese consumption of oil increased by almost a million barrels per day. The price of oil had to rise by whatever it took to persuade the rest of us to decrease oil consumption, despite the strong growth in world income.

The historical experience has been that even very large oil price increases cause relatively little immediate change in the quantity of oil consumed. The response of consumers to energy price increases over 2004-2006 was, if anything, even smaller than those historical estimates. It was not until the price rose substantially over $3 a gallon that we began to see some significant changes on the part of American consumers. Unfortunately, those changes in spending patterns can be quite disruptive for certain key economic sectors and seem to be part of the mechanism by which the earlier oil price shocks had contributed to previous economic recessions. As I note in my testimony,

The kinds of economic responses we saw between 2007:Q4 and 2008:Q3 were in fact quite similar to those observed to have followed previous dramatic oil price increases.

One example is the plunge in sales of domestically manufactured SUVs. That this was caused primarily by consumers' responses to rising gas prices is evidenced by the fact that sales of imported smaller cars were rising significantly at the same time that Detroit began to bleed. The sales drops for domestic auto manufacturers made a measurable contribution to GDP and employment losses. Declines in consumer sentiment and overall spending were also similar to the patterns we saw following earlier oil price shocks. A model of the response of the economy to an oil price increase that I published in 2003 could have predicted the level of U.S. real GDP for the third quarter of 2008 with an error of less than 0.2 percent one year in advance.

Certainly there were other problems for the economy during the first year of the recession, notable among which would be the housing sector. But housing was actually a bigger drag on GDP over the fourth quarter of 2006 through the third quarter of 2007 -- the year before the recession -- than it proved to be during fourth quarter of 2007 through the third quarter of 2008, the first year of the recession. My testimony concludes:

Something else, in addition to the pre-existing problems in the housing sector, contributed to tipping the scales from an economic slowdown into a self-feeding dynamic of falling output and employment. I see little basis for doubting that a key aspect of that new drag on the economy resulted from the effects of the oil price shock.

There is also an interactive effect between the oil price shock and the problems in housing. Lost jobs and income were an important factor contributing to declines in home sales and prices, and we saw the biggest initial declines in house prices and increase in delinquencies in areas farthest from the urban core, suggesting an interaction between housing demand and commuting costs. Once house price declines and concomitant delinquencies reached a sufficient level, the solvency of key financial institutions came to be doubted. The resulting financial problems turned the mild recession we had been experiencing up until 2007:Q3 into a much more severe downturn in 2008:Q4 and 2009:Q1. Whether those financial problems were sufficiently insurmountable that we would have eventually arrived at the same crisis point even without the extra burden of the recession of 2007:Q4-2008:Q3 is a matter of conjecture. But that oil prices made an important contribution both to the initial downturn as well to the magnitude of the problems we’re currently facing seems to me to be indisputable.

I then go on to discuss some policy steps that might have mitigated the oil price spike of 2007-08, including a slower approach to interest rate cutting by the Federal Reserve, sales of oil out of the Strategic Petroleum Reserve, and adjustments in environmental regulations. I nevertheless caution:

The reality is that no policy could have prevented a substantial increase in the price of oil between 2005 and the first part of 2008.

Finally, I offer some thoughts on the economic implications of the bump back up in oil prices over the last few months:

Retail gasoline prices have risen about 50 cents-a-gallon from their low in December. That takes away about $70 billion from consumers’ annual spending power, which is hardly helpful for the broader challenge of restoring household balance sheets to a level where spending could be expected to pick back up. But let me emphasize that although I believe that the initial spike in oil prices was an important element of the process that produced our current difficulties, we are currently at a point at which the multipliers and spillovers associated with the recession dynamic itself have become far more important factors than the price of oil.... Notwithstanding, the recent rise in oil prices again underscores the present reality of the long-run challenges. Even if we see significant short-run gains in global oil production capabilities, if demand from China and elsewhere returns to its previous rate of growth, it will not be too long before the same calculus that produced the oil price spike of 2007-08 will be back to haunt us again.

--James D. Hamilton is professor of economics at the University of California, San Diego. He blogs regularly about the economy at Econbrowser.

By Sara Goo  |  May 20, 2009; 10:00 AM ET
Categories:  Energy and Environment  
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I think the statistical predictability of the depth of this recession based on oil pricing should be subjected to a multiple regression analysis. Otherwise, this all makes perfectly good sense, IMHO.

Posted by: mark_in_austin | May 22, 2009 9:03 AM | Report abuse

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