America Needs to Chill Out about Oil Prices

Oil prices matter far less for economic activity than we give them credit for. 

American diplomacy operates under a perennial fear of disrupting oil markets—from Moscow to Tehran, and from Caracas to Baghdad, foreign policy resembles someone trying to tiptoe towards the treasure without waking the sleeping dragon guarding the gates. Daily, we are told that a fragile America will collapse if oil prices rise further. As Daniel Yergin, the Pulitzer Prize–winning author of The Prize, put it, if oil production in the United States were not rising, “We’d be looking at an oil crisis. We’d have panic in the public. We’d have angry motorists. We’d have inflamed congressional hearings and we’d have the US economy falling back into a recession.” These views are common and hark back to the 1970s, when two oil shocks are thought to have brought on “stagflation,” a mix of anemic growth, persistent inflation and high unemployment. Then, in 1983, James Hamilton pointed out that an oil-price spike had in fact preceded every American recession except one since World War II. Oil has haunted America ever since.

Yet oil prices matter far less for economic activity than we give them credit for, and the tiptoeing around the oil market is largely unnecessary. The view that cheap energy is good for the economy and expensive energy is bad is based on half-truths and misconceptions. Its broadest premise is that postwar posterity was fueled by cheap energy; as Michael Ross explained, “The 1973 oil crisis shocked most Americans because it was a rebuke to the growing prosperity of the postwar era, which was built on an ocean of cheap energy.” But the term “cheap” is relative—prices matter, but so do incomes, since richer people can afford to pay more for energy. Energy prices declined in real terms after World War II, but spending on energy did not. In the 1950s and 1960s, Americans spent 6 percent of their disposable income on energy, just over the 5.5 percent they spent in 1929, the first year for which we have data. This 6 percent is also about the same as in the 1970s, before and after the first oil shock, even though energy use per capita was 24 percent higher than in the 1960s. Yet the 1950s and 1960s were undisputed high points for the economy—real per capita incomes have never grown faster. There is no basis for the claim that the economy grew after World War II because it was unburdened by energy spending.

The link between oil and recessions is similarly spurious, yet the coincidence between the two is too powerful to ignore. A 2011 article captured the cognitive dissonance: “The precise causal links between oil prices and the well-being of national economies are murky and much debated, but as the economist James Hamilton has noted, all but one of the 11 recessions the United States has experienced since World War II were associated with a rapid increase in the price of oil.” Translation: the coincidence is too strong for this to be just a coincidence. Even so, there is no evidence that any recession before 1973 was linked to oil. Contemporary accounts place no emphasis, even in passing, to oil as either a trigger for any of these recessions or a contributing factor to their trajectories (they mention, however, other commodities or inputs such as agriculture or steel). Two recessions (1953–1954 and 1969–1970) were largely due to the demobilization efforts linked to the Korean and Vietnam Wars, respectively, with a strike at General Motors being an additional drag in 1970; other recessions marked general corrections in investment or consumer spending unconnected to oil prices.

The link between oil and recessions appears more plausible in the 1970s and 1980s, but with caveats. For one, there were other pressures besides oil. The 1973–1975 recession followed the winding down of the Vietnam War, the collapse of the Bretton Woods financial architecture, chronically higher inflation and persistent budget deficits. Similarly, the 1980s recessions followed a severe tightening in money to fight inflation, as the Federal Reserve raised interest rates to the high teens three times in just two years. Moreover, the 1973–1975 and the 1980 recessions both followed housing booms and busts—booms far greater than the most recent one in the last decade. The five years with the most housing construction starts in history are, in order: 1972, 2005, 1973, 1971 and 1979. In other words, four of the top five came right before the recessions of the 1970s and 1980s. Residential investment grew by 70 percent in real terms in just a few years before the 1973–1975 and the 1980 recessions (by contrast, it grew by 36 percent from 2001 to 2005). The bust was painful in both cases.