October 30, 2007
Shock treatments
With US crude now over $93 and heading for $100, economists have been scrambling for their models of how oil shocks affect the economy.
James D. Hamilton’s Econbrowser has a characteristically excellent round-up of the arguments, picked up by Brad DeLong. He cites a good article by Jerry Taylor and Peter VanDoren of the Cato Institute, arguing that
"the inflation, unemployment, and recession that supposedly follow oil price shocks are nowhere on the macroeconomic radar screen. If the economy goes into a tailspin, it will be in response to bad news in the housing market, not the oil market."
Similar arguments are made by Greg Mankiw at Harvard, a former chairman of George W. Bush’s Council of Economic Advisers, and Mark Perry, a professor at the University of Michigan. Both use a chart showing that the energy intensity of the US economy, as measured by British Thermal Units per dollar of GDP, is today less than half what it was in 1950, suggesting that the economy’s vulnerability to high oil prices has also dwindled.
Probably the last word on all this, though, came from the IMF back in April’s World Economic Outlook (chapter 1), which drew a contrast between a supply shock (bad for growth) and a demand shock (which could be good for growth). What we are going through now looks like a textbook example of that growth-friendly demand shock.
Prof Hamilton sounds a warning, though. As he points out, the share of spending on oil in US GDP fell from the early 1980s to the early 2000s in part because the price of oil was falling. As the price has risen, the inelasticity of demand has meant that oil’s share of total spending has been rising, and that could make the US and other oil-consuming countries more vulnerable to a price shock. He writes:
"We can avoid a recession only as long as consumers and firms remain as confident as Taylor and VanDoren above, and everything outside of housing continues to do well. Should we count on that as oil surges to $90 and beyond? I am not so sure."
If global growth does hold up, one consequence would be that the demand for oil would stay strong. This year, the picture has broadly been of little change in oil demand in the OECD countries - with a small rise in the US cancelling out a small fall in Europe - but reasonably healthy growth in China and the oil-producing countries. For next year, both the IEA and Opec expect something similar. (Opec figures in the Monthly Oil Market Report, available as a PDF.)
That means we could see the price of oil being driven yet higher, and there must be some level at which the price will at last begin to bite on global growth. We can only hope we don’t get there.
Stuart Staniford said this in commenting Dr. Hamilton’s post. I think is worth remembering:
“What continues to stun me in discussions by economists of this issue is the lack of recognition that the percentage price increase is not the proper metric of the size of an oil shock. Because oil shocks occur for geopolitical reasons (particular countries have wars, revolutions, etc), the natural size of oil shocks is set as a percentage of supply. Past oil shocks (eg in the 1970s) have been of O(5%) reduction in global supply. That’s a serious reduction in the flow of energy through the economy which is bound to result in reduction in economic activity somewhere (for lack of energy with which to physically perform the activity in question).
By contrast, the current “oil shock” is instead a plateau in supply of oil, but not yet an actual reduction (at least not to any significant degree - see latest data here). Thus although oil is almost as expensive in inflation adjusted terms as during the 1980 shock , this shock is in fact significantly milder than that one (at present). That price is almost as high during a much milder shock reflects the fact that demand has become more inelastic since the 1970s.
If we were now, for some reason, to lose 5% of supply, oil would shoot up to somewhere in the general vicinity of $200. Then we would discover that the economy is no more resilient to oil shocks than it has ever been.”
Posted by: Peaknik | October 30th, 2007 at 8:07 am | Report this commentOil geopolitics. The comment above suggests the United Nations should urgently address international property rights.
There are hundreds of claims to be decided upon, not least the Arctic, Antarctic and the Falkland Islands. At present the unenforceable rules encourage ‘might makes right’.
Posted by: Slightly Optimistic | October 30th, 2007 at 4:19 pm | Report this commentPeaknik: Good point. I agree that it is very important to look at volumes as well as prices.The IMF study I cite supports your argument: a price rise caused by supply disruption is much worse for the world economy than a price rise caused by strong demand.
Posted by: Ed Crooks | October 31st, 2007 at 1:57 am | Report this comment