Gas prices continue to climb, and, as I predicted last week, so does the volume of gas price punditry. That post sparked a sequence of smart thoughts from Matt Yglesias, Ryan Avent, Tim Duy, and Karl Smith. They collectively raise two big points that are worth talking about. (There’s also a lot of discussion of Federal Reserve policy – see here for my thoughts on that.)
Yglesias begs for some elaboration. Why, he asks, shouldn’t we expect the market to blunt most of any shock? (Side note: I never said that it wouldn’t; I just said that this looked more like a supply shock that one might first imagine.) If, say, Chinese growth is driving up oil prices, won’t we see increased demand for U.S. exports, like “airplanes and soybean oil and Friends reruns”? (There’s a lot of talk of Friends reruns in that post; perhaps his SEO experts know something I don’t.) Alternatively, if they (and oil exporters) don’t consume more, that means they’re putting more money away; that should drive down U.S. interest rates and help prop up the economy.
Matt speculates that the latter link might be broken: with nominal interest rates stuck at the zero bound, it’s impossible to drive them down. I think that’s wrong. The short term Fed funds rate is indeed stuck near zero, but there are a lot of other rates that aren’t. So long as money can be pumped back into longer term public debt, agencies, and private debt, this particular channel can still help blunt any oil shock.
Where I think there may be a bigger problem is in the assumption that increased demand for U.S. exports will balance things out. Shifting trade patterns takes time – perhaps not years, but certainly months, and perhaps more. Dreamliner orders take time to shape up, even if Friends reruns (I’m learning!) can be ordered on demand. In the meantime, the U.S. economy can experience a big net drop in demand. I’m not trying to imply that we’re about to be crushed; I do think, though, that traditional demand shock thinking may be insufficient to the present task.
This story is all about demand. Ryan Avent, though, makes an important point:
“We also need to note that rising oil prices represent both demand shocks and supply shocks to the American economy. Dear oil can impact demand directly, by reducing real household income, and indirectly, by influencing consumer confidence. If rising oil prices were purely a problem of demand, then the only thing to fear would indeed be fear itself—by households or by overactive central banks. They are not, however. Soaring oil prices can also dent an economy’s productive capacity.”
It seems to me that there are two problems with this. The first is on demand: the problem isn’t only fear; it’s cash flow. Absent irrational fear, neither Avent nor I are going to cut back on purchases because we’re spending a bit more on gas. But there are a lot of people of more meager means, who also don’t have access to credit, who can’t just smooth their consumption. They’ll cut back on non-oil spending as a simple matter of necessity. The second problem is on the supply side: the numbers just aren’t very big. Standard economic theory tells you that the impact of rising oil prices on productive capacity should be proportional to the reduction in commercial oil use that the price hike prompts. But yhose reductions tend to be very small; indeed if there’s one thing about oil that most economists agree on, it’s that supply side factors can’t come close to explaining the impact of oil shocks.
None of this is either alarming or comforting. The links between oil and the macroeconomy remain pretty murky. That suggests that policy should be more about risk management than anything else.