Dispatch December 2007

Oil Shocks

Clive Crook warns that it may soon be time to panic about the price of oil

Back in 2003, economists fought over the Iraq war’s likely effect on oil prices and the economy. Some warned that the conflict might push oil as high as $40 a barrel—$2-a-gallon gas!—and that the economy would likely reel. Scare-mongering, replied others: Oil would spike at less than $40 and settle back down in the low twenties; there would be no recession.

In retrospect, the pessimists were not nearly pessimistic enough about price of oil. Yet look at the economy. While it has slowed lately, most analysts have fingered the housing market and the sub-prime mortgage mess. Nearly $100-a–barrel oil is not helping, but has not gotten the blame. A quadrupling of the price of oil since 2003 was apparently taken in stride.

Financial bubbles often do not burst until the last skeptics—the ones who called them bubbles early on, and rolled their eyes as speculation raged—have capitulated to the mania and bought in. Once nearly everyone is convinced that the rise in prices has some real economic foundation after all, and not before, the whole thing goes pop. The pattern repeats over and over. A parallel suggests itself. When even the people who were worried about $40 oil have stopped worrying about $100 oil, it may be time to panic. As the price of oil goes ever higher, we seem to get ever less anxious about it. In the June 2006 Atlantic, I explained why oil at more than $50 a barrel was having so little effect. But now it’s almost double that. What ought to be obvious might therefore be worth restating: The higher it goes, the more likely it is do real harm.

Reasons why the effects have been mild up to now are not hard to find. Most importantly, the economy uses oil much less intensively than it once did. Since 1970 the U.S. economy has grown by roughly 200 percent; its consumption of oil has risen by just 40 percent. Since oil is a smaller component of the economy than before, fluctuations in its price have less impact.

But James Hamilton, an economics professor at the University of California, San Diego, and a long-time student of the economics of oil shocks, points out that if the price goes much higher, oil will again loom as large in the economy as it did in 1980. Back then, the dollar value of oil consumption was equivalent to 8 percent of national income. Between 1985 and 2003, as the real price drifted down and new technologies spurred energy efficiency, this ratio was mostly 2 percent or less. At $100 a barrel for a year, oil would consume about 5 percent of GDP; at $150 a barrel, a little over 8 percent – or as much as it ever has in relation to the economy.

Even at that price, the economy still wouldn’t seem as vulnerable to oil as it was in the 1970s. For one thing, as Hamilton points out, the domestic auto industry’s importance to the economy has also fallen, and besides, car makers now offer more small cars and fewer big ones—so consumers who fear high gas prices can (and do) buy smaller models, rather than not buying at all.

A recent paper by the economists Olivier Blanchard and Jordi Gali attributes the resistance of the U.S. to the oil bug to three other things in addition. One is that previous oil shocks happened alongside other bad surprises. In the 1970s and 1980s, in other words, we were just unlucky. The economy also may be more flexible—a point also mentioned by the Congressional Budget Office in its own recent study, citing deregulation (notably in transport), foreign competition, and advances in information technology. Today’s economy just copes with shocks of every kind more smoothly than it used to. Finally, the Federal Reserve is nowadays better equipped to do its job.

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