The Catch-22 Recovery: We Need to Keep Gas Prices Low

How do we prevent more expensive oil from killing hiring next time around?

600 gasoline prices REUTERS Mike Blake.jpg

Since May, the U.S. economy has struggled. From May through July, just 72,000 new jobs per month were created on average. Yet February through April averaged 215,000 per month. What killed the promising progress we were seeing earlier this year? A couple of factors are often blamed, but the biggest problem was rising gas prices. Even though they have been declining lately, this might not be the last time that this recovery is plagued by consumer sentiment plummeting due to the price at the pump. We could see gas prices create a sort of catch-22 that makes it difficult for the U.S. economy to stay on its feet.

Dissecting the Shocks of Last Spring

For starters, is it really fair to blame gas prices for the slowdown we've seen? The three common causes that people tend to name include Japan's earthquake, Middle East instability, and global demand boosting oil prices. The first issue had some supply chain effects, but shouldn't have significantly impacted consumer sentiment. The second cause also would have had virtually no effect on spending if it hadn't caused gas prices to rise more quickly. That leaves the third cause: consumers pulled back their spending due to the psychological and practical consequences for having to pay more for gasoline.

Although the unrest in the Middle East had some effect on prices, most of the reason why oil prices rose can be traced to global demand increasing. As economies recovered, they needed more oil. Since supply didn't rise in response, the price increased.

The Troubling Loop

In July, however, the economy appeared to begin improving again, compared to May and June. This is likely due to spending returning. Retail sales were up by 0.5% during the month, the best growth since March. Why are Americans spending more? That's easy: gas prices began to decline again. Since early May, they're down about a quarter per gallon, or 7%.

Indeed, prices are expected to continue to fall, since the global economy has been weak over the past couple of months. But as gas prices decline and spending returns, the economy will begin to strengthen again. And as it gains steam, gas prices will presumably begin rise in response.

When that happens, can we expect consumer spending to pull back again, once gas prices approach $4 per gallon? Probably, since that's what happened last spring. You can see how this cycle can continue over and over again. We'll never have a strong, resilient recovery as long as the economy begins to slow just as it finally gains traction.

Why Gas Prices Matter So Much This Time

Why doesn't this happen in other recessions? For one thing, Americans are extra sensitive to gas price increases in this recovery. As long as unemployment is high and the real estate market is weak, sentiment will have a hard time rising to a level where people feel comfortable enough to absorb a significant increase in energy costs.

Think of it this way: the U.S. economy is like a patient that has a serious illness from which it can only slowly recover. If that patient contracts some infection, then her condition will worsen. Only if she stays as healthy as possible will she gradually recover. Rising gas prices are like an infection attacking the economy's already weak immune system. If the economy was healthier to begin with, gas prices wouldn't have as significant an effect.

Searching for Solutions

Any solutions to attempt to help the economy to heal faster need to address either its underlying weaknesses, like the housing market or unemployment, or ensure that rising gas prices don't prevent a prolonged hiring spree. The housing market problem will be tough to fix quickly, due to its severity and logistics, though some policies might help more than others. The government can only help to cut unemployment directly through job programs, for which there's little money or will in Washington to create.

That leaves gas prices. The U.S. may want to consider creating a price ceiling for average gasoline prices, perhaps at around $3.50. In order to ensure that consumers don't have to pay more than that for gasoline, one step could be to relax taxes when prices begin climbing past that mark. When taxes can't be lowered any farther, perhaps subsidies can help cut prices.

Such an initiative would obviously cost the government some money, but if it helps to ensure that a recovery endures, it would be well worth the cost. It could also be limited in time frame until the other underlying weaknesses begin to strengthen. For example, the ceiling could be in effect until home prices stop falling and the unemployment rate hits 7%.

Other solutions might be thought up as well, but the U.S. must do something to deal with the problem that rising gas prices pose for future economic expansion. If the labor market continues to improve a little only to weaken in a sort of infinite loop, then the nation's growth will be lower and more Americans will suffer from unemployment for longer.

Image Credit: REUTERS/Mike Blake