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How Bad Could High Gas Prices Be?

by Michael Levi
February 28, 2012


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.

Post a Comment 4 Comments

  • Posted by Jack Riggs

    Isn’t there also an increased risk premium in the current runup of oil prices?

    [ML: Yes. But that has a physical counterpart: inventory buildups. Doesn’t that make it possible to still analyze the macroeconomic impacts in terms of physical developments?]

  • Posted by pjc

    You’re still missing the key element in this equation – natural gas prices!

    Natural gas prices are insanely cheap in the US. Why is this important – because people make stuff with natty gas, and move stuff with oil. (And the latter is much less important to the overall prices than the former).

    So electricity in the US (which is priced around nat gas) is cheap! Heating your home is cheap! Fertilizer is cheap! Propane is cheap! Plastics are cheap! All this stuff made from gas is cheap!

    It is here anyway…. basically energy in the US is cheap, so long as you’re using that energy for some stationary purpose.

    This will hugely blunt the impact of high oil prices on the US economy. Moreover, since gas **isn’t** cheap overseas, it gives the US a huge competitive advantage.

    Moreover, low interest rates means cheap car loans means cheap new cars. So the low interest rate, high gasoline price combination is sort of a natural “cash for clunkers” program – i.e. it’s expensive to hold on to your old 12 mpg car, but it’s easy to buy a new 30 mpg car.

    These two things – low natty gas and low interest rates – make the high oil prices in 2012 fundamentally different than the high oil prices of 2008. Four years ago – interest rates were not low at all, and natural gas was going through the roof.

  • Posted by RLC

    It is not that complicated, despite all the experts over-analyzing this.
    The Crash was not caused by a monetary burp, it was caused by HIGH GAS PRICES. Ordinary everyday people cut all their spending when gas prices skyrocket. If gas is costing them 40.00 a week more, they will cut spending by 120.00 or more in anger,,,,and fear. Economy tanks, very simple

  • Posted by Vince Salluzzo

    Petition to lower artificially elevated gasoline prices
    Gas prices have been inflated artificially. Us for the US has posted a petition to be sent to Congress that makes a good deal of sense. You can read, sign the petition, and verify your signature for your elected representatives by going here

    The petition, upon completion, will be sent automatically to every federal elected representative of every signor. You will be asked your address when you go to sign the petition, so that they can determine who your elected representatives are. You will also be made an observer/member of so that you can follow the results of the petition, and see if your elected representative took any action on the petition.

    Obviously, the more signatures gathered, the higher the probability will be that our elected reps will take action on our behalf. Please help circulate the petition by posting the link on your social media pages, such as Facbook, Twitter and Linkedin.

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