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.
Oil prices did play a role in the 1970s, but not as “supply shocks.” Rather, oil prices, together with supply shortages, affected consumer spending on automobiles. General Motors explained thus in its 1979 annual report: “Many potential car buyers deferred their purchases. Others chose smaller, more fuel-efficient cars as part of an escalating trend.” These shifts accounted for most of the change in economic output that could be attributed to oil, which was small to begin with relative to other factors. Motor vehicle sales reached an all-time record before the first oil shock, and 1973 still ranks as the second-best year ever for sales (1986 is number one). After the oil shock came a brief lull, but by 1977 and 1978, auto sales had recovered (they were the fourth- and third-best years ever, respectively), even though oil prices did not fall. The oil shock shifted consumer preferences, and the auto companies struggled to adapt. Sales of imported cars boomed because they were more fuel efficient, and General Motors even observed that compact cars fetched more in the secondhand market than sedans in 1974—a fact that surprised the automaker enough to mention it in its letter to shareholders. In 1979, General Motors observed a similar gap, saying it had “to reduce production schedules and temporarily [idle] some workers,” but “those plants producing smaller cars were working full, even overtime, schedules.”
After 1982, the connection between oil prices and recessions becomes highly tenuous. The 1990–1991 recession, for instance, started in July 1990, a month before Iraq invaded Kuwait and pushed up oil prices temporarily. Technically, this was not even a recession preceded by an oil-price spike, although it is often counted as one. After 1992, the price of oil has been so volatile that any recession, regardless of timing, was certain to have been preceded by an oil-price spike, and so the observation that oil prices and recessions are correlated is essentially meaningless. After all, neither of the two recessions (2000–2001 or 2007–2009) was really linked to oil prices, the former having been caused by a stock-market bubble and the latter by a housing bubble, a debt overhang and a financial crisis. Even so, when oil prices started to rise in the last decade, they once again altered consumer preferences, but now the shift was not just to smaller and more efficient cars but also to motorcycles. Between 2007 and 2012, total registrations for light-duty vehicles fell by 1.9 million, while registrations for motorcycles rose by 1.3 million. Weaker consumer spending on cars was a mild drag on the economy, but once again it paled in comparison to the other drags on the economy such as residential investment, the drying up of credit, de-leveraging and others.
The post-1982 experience also put to rest the notion that high oil prices cause inflation. Of course, it is questionable whether oil prices were ever responsible for inflation in the 1970s, despite the role we have since ascribed to them. For instance, Robert Barsky and Lutz Kilian have argued persuasively that the inflation of the 1970s far predated the oil-price shocks, and that loose and unstable monetary policy appears far more culpable for it than oil. Then, in the last decade, oil prices rose fivefold in real terms, while core inflation, excluding food and energy, remained anchored at low levels, dispelling for good the idea that oil and inflation must come together, especially when monetary policy remains credible.
Naturally, it is not easy to give up on the idea of oil as a commodity that can bring down economies—we have been taught otherwise for so long. Yet getting this right has immense implications for diplomacy and domestic policy. Reforming subsidies or combating climate change is easier when we disavow the notion that higher energy prices spell economic catastrophe—a reality that applies beyond America. Similarly, it is easier to pressure or sanction states that hide behind the fear that any action against them would destabilize oil markets. We give oil too much credit; our options and maneuverability will expand by letting go of our irrational fear of oil.
Nikos Tsafos is a founding partner at enalytica and is currently advising the Alaska state legislature on gas commercialization issues. He was previously a director with PFC Energy, with a portfolio that included overseeing research and gas fundamentals and leading the firm’s global gas consulting practice.