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Will High Oil Prices Crush the U.S. Economy?

by Michael Levi
February 24, 2012

Rising gasoline prices have a way of bringing out the hidden energy pundit in all of us. Most speculation tends to focus on why oil prices might be rising and on how high they might go. But a second strand of questioning is probably even more important: What do rising prices mean for the world? There’s a lot of wisdom that’s accumulated over the past few decades in attempts to answer that question. But I have to wonder whether there aren’t some fundamental changes that might render a lot of it obsolete.

It’s always been difficult to pin down the economic impact of high oil prices for one simple reason: high prices and high economic growth tend to go hand in hand. Strong economies drive rising oil demand which in turn raises gasoline prices; even if that shaves off a bit of economic growth, the net outcome still looks positive. Think of it like wind resistance in a foot race: it slows you down, but it probably isn’t going to send you heading backwards.

One of the main ways that economists have tried to cut through this complication is by distinguishing between high oil prices that result from demand spikes and ones that follow supply cuts. Demand driven oil shocks should be relatively benign. Supply driven ones, in contrast, should be far more devastating. For many observers, that explains why the 1970s oil shocks were so damaging, and why many subsequent ones were far less severe.

I suspect, though, that something has changed in the world economy to throw a wrench in all of this. We now live in a world where U.S. economic health doesn’t drive global oil demand and prices the same way that it used to. Once upon a time, if the U.S. economy was flagging, the only way to generate a oil big price increase was to have a supply shock. That meant that oil spikes were rare in periods where the U.S. economy was shaky; for the most part, oil shocks hit when the U.S. economy was relatively strong, probably blunting their effects.

But we now live in a multispeed world. Western economies can be on their knees, but oil demand can still be on the upswing due to healthy growth in China, India, and other emerging economies (not least those that also export oil). It’s become far more likely that we’ll have price spikes during periods where the U.S. economy is already weak. That makes historical precedent harder to go by.

There’s another way to think about this. I mentioned that economists like to split oil spikes into ones driven by low supply and ones spurred by high demand. Casual analysis would put a price spike driven by economic growth in the developing world in the latter category. But what seems like a demand shock if you’re sitting in Shanghai looks a lot more like a supply shock if you live in San Francisco. Surging demand in the developing world takes barrels off the market in the same way that falling production in Iraq or Nigeria would. My guess is that these new “demand” shocks will hit the U.S. economy much more like supply shocks have in the past.

That’s bad news. So is there anything the United States can do beyond getting its energy policy right? I’ll throw one idea out there: it could work on boosting export relationships with those countries that are driving economic growth. If an economic boom in the developing world rasies oil prices, and that slows the U.S. economy down, strong export relationships with the sources of that growth will tend to provide a countercyclical balance. There’s some evidence that Japan benefits from a similar sort of arrangement with oil exporters: the Japanese current account balance tends to improve, rather than weaken, when oil prices jump. Perhaps the United States could ultimately do the same?

Post a Comment 5 Comments

  • Posted by Earl Richards

    Google the “Global Oil Scam” by Phil Davis. Purchase electric cars and solar panels.

  • Posted by Guillaume Barthe-Dejean

    “There’s some evidence that Japan benefits from a similar sort of arrangement with oil exporters: the Japanese current account balance tends to improve, rather than weaken, when oil prices jump. Perhaps the United States could ultimately do the same?”

    Wouldn’t you then be hit by inflation twice? You would effectively be (a) hit by higher oil prices, and (b) importing inflation from those energy-intensive manufacturers in the developing world?

    Even if this led to a marginal improvement in the current account balance, jumps in oil prices would continue to drive the dollar down (they’ve been inversely correlated for at least the last five years) … which then makes energy even more expensive in the US, thereby contributing to the economic slowdown?

    [ML: I think you've got the trade flows backward. I'm talking about *exporting* to these countries. That doesn't *import* inflation.]

  • Posted by Lorne Stockman

    Surely the best thing we can do is double down on efficiency and diversification. The less oil per unit of GDP we consume the less high oil prices impact the economy and if we can develop and manufacture efficiency technology we can export it. America is still a center of technology innovation and it should press home its advantage on this.

    Obama has it right on this and we shouldn’t let GOP exploitation of Solyndra stand in the way.

  • Posted by Michael Giberson

    “My guess is that these new “demand” shocks will hit the U.S. economy much more like supply shocks have in the past.”

    This seems right as a short term analysis, but I think demand shocks and supply shocks have different long run consequences.

    Supply interruptions usually promise to correct themselves within relatively short order. Military disputes get resolved, political power is consolidated, and the oil flows again. So while supply interruptions produce price spikes, the long term price outlook doesn’t change much and so little long term investment in new capacity emerges elsewhere.

    Demand shocks, on the other hand, can endure long enough to reward long term investment decisions. The “shock” isn’t a temporary disruption, but rather a potential take-off to a sustained higher quality of life for billions of people. Even if growth rates in China, India, and elsewhere moderate due to high energy prices, the demand for oil is likely to stay high.

    This investment will likely bring additional oil production onto the market after a while (to the frustration of peak oil theorists), and the additional production will act to moderate the price increase.

  • Posted by Bob Loblaw

    Some good points are made here but Ill focus where i disagree.

    “”It’s always been difficult to pin down the economic impact of high oil prices for one simple reason: high prices and high economic growth tend to go hand in hand”"

    Except that isnt true. I think if you did a regression analysis, youd find no positively correlated relationship between GDP and oil prices (as GDP goes up, oil prices go up). The period 1982-99, had strong economic growth and falling prices not only in real but in nominal terms

    I recall the exact same arguments being made back in 2005-07 when oil prices were rising and GDP was rising: Rising oil prices were demand driven, not the result of a supply disruption, thus would not cause a recession.

    The recession of Dec 2007-July 2009 need to be broken into two parts. Pre-Lehman and Post-Lehman (Sept 2008). The US Economy was already in recession prior to Sep 2008. It was a shallow recession, but one that had actually, in duration, been as long as the average post 1945. Not all quarters were negative but job losses averaged just over 100,000 per month.

    The UCLA Anderson School of Business has done a study of the period Dec 2007-Aug 2008 and has concluded that the early part of the recession was indeed driven by rising oil prices, not housing.

    “”Obama has it right on this and we shouldn’t let GOP exploitation of Solyndra stand in the way.”"
    So failure so should not stand in the way of achieving utopia…LOL

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