Oil Shocks

— By Kevin Drum

| Wed Apr. 22, 2009 8:27 AM PDT

Ryan Avent points today to a paper by Jim Hamilton suggesting that the real cause of our current recession is the spike in oil prices between 2007-2008.  Here's Hamilton on the implications of a model he originally constructed in 2003:

I used [] historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

....Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.  The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don't fully believe myself.

Well, I don't fully believe it either.  But do I believe that the oil spike played a significant role?  You bet.  I don't have any kind of background in econometrics, but I can create simple-minded charts showing how the economy responds to sharp rises in oil prices, and four years ago I did just that.  My chart is on the right, and it shows that every time since 1973 that oil prices have risen by 50% or more in a short period, the American economy has tanked — and the bigger the spike, the bigger the tank.  The far end of my chart is labeled with question marks, but of course we can now fill in that data: the rise in oil prices that began in 2003, retreated a bit in 2006, and then spiked sharply starting in 2007 did indeed touch off a recession.  And as in previous episodes, the fact that it was a big rise meant that the result was a big recession.

Plus there was the whole subprime thing, a huge credit expansion, the rise of financial wizardry, the end of the housing bubble, and so forth.  A perfect storm.  But if you want to persuade me that oil prices played a role too, I'm all ears.  I'd be pretty surprised if it were otherwise.

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Comments

Correlation/causation

Submitted by dbeach (not verified) on Wed Apr. 22, 2009 9:04 AM PDT.
The problem with this whole analysis is that it assumes the causality goes from high oil prices to lousy economy. But the oil prices were high in the first place because the economy was booming, with GDP probably above trend. The reality is that neither oil prices nor GDP is independent with respect to the other. In order to estimate this sort of thing econometricians use VAR models (vector autoregression) where all of the variables are assumed to be both cause and effect.

More/less sensitive to oil price?

Submitted by dr2chase (not verified) on Wed Apr. 22, 2009 9:10 AM PDT.
On the more-sensitive size, we've ben working on a lot of long-commute build outs, which, when oil got expensive, made all that housing less attractive. We've also been buying big fat cars/trucks much more than in the past, and US auto companies in particular had focussed on that business. Gasoline gets expensive, there goes our auto companies. On the less-sensitive side, aren't we doing a better job at GDP per barrel of oil consumed? On the other hand, isn't all of Europe and Japan also doing a far better job of GDP per barrel of oil than us?

Credit Bubble

Submitted by PeakVT on Wed Apr. 22, 2009 9:22 AM PDT.
There was a bubble in everything that could be financed, so on top of a "normal" increase due to a growing economy there was a pump/dump going on. IIRC G$ made out like bandits by shorting at the same time they were pumping.

There is a (weak) argument to be made.

Submitted by BigTom (not verified) on Wed Apr. 22, 2009 10:50 AM PDT.
There is a (weak) argument to be made that the credit bubble was blown up to mask the fact that our economy was no longer growing. And the claim can be made, that one of the bigger causes of the stagnation in the real economy is that per capita oil production is long past peak. IMHO, that ascribes far too much to a single cause to be realistic. But I do think the effect may be important, and almost entirely ignored by mainstream economics. Because of commodity resource constraints the material side of the economy can no longer grow as fast (or perhaps not at all in the near future), as we had become accustomed to. That level of return may no longer be possible in a resource constrained world. So many of our institutions are designed around the ability to make a certain long term rate of return on capital, that such a phase change will not be seemless. Malthus was too far ahead of his time to be appreciated.

There is a (weak) argument to be made.

Submitted by BigTom (not verified) on Wed Apr. 22, 2009 10:51 AM PDT.
There is a (weak) argument to be made that the credit bubble was blown up to mask the fact that our economy was no longer growing. And the claim can be made, that one of the bigger causes of the stagnation in the real economy is that per capita oil production is long past peak. IMHO, that ascribes far too much to a single cause to be realistic. But I do think the effect may be important, and almost entirely ignored by mainstream economics. Because of commodity resource constraints the material side of the economy can no longer grow as fast (or perhaps not at all in the near future), as we had become accustomed to. That level of return may no longer be possible in a resource constrained world. So many of our institutions are designed around the ability to make a certain long term rate of return on capital, that such a phase change will not be seemless. Malthus was too far ahead of his time to be appreciated.

If you believe collective

Submitted by urban legend on Wed Apr. 22, 2009 12:43 PM PDT.
If you believe collective confidence in the future is the key thing, big oil price increases certainly shake that up -- as do far of losing everything from a health problem, actually losing half of the wealth you thought you had when the bubbles burst, failure even during a GDP growth period to produce new jobs, pensions disappearing, etc., etc. And what's weak about the argument that the bubbles were encouraged to mask fundamental weaknesses of a "jobless recovery"?

Denial - a river in Egypt

Submitted by Trippp on Wed Apr. 22, 2009 12:57 PM PDT.
Yeah, Like you've all pointed out, the world economy and cheap energy are completely entwined and intermixed. And the age of cheap energy is ending, but it seems that concept is so horrible it is literally unthinkable for most people. I could understand if most people said "I know it's true, but I can't do anything about it" but it seems to me most people deny that it is true at all, and yet the facts and reality are right there in front of all of us. Sigh. Tripp

Not Denial

Submitted by MarkH on Wed Apr. 22, 2009 1:17 PM PDT.
I think it's just the realization that the kinds of changes we need cannot be made by individuals. Remember Kevin's post on waste and how little difference a consumer's buying choices make? Same thing with macro-economics. The government has to lead. Same thing with health care reform. We're spending between 150-300% more than most other people and getting less for it. Will industry find a way out? Fat chance. Government has to lead.

I go one further, stepping

Submitted by Mattyoung (not verified) on Wed Apr. 22, 2009 2:48 PM PDT.
I go one further, stepping out into speculation. Online shopping took over half of Christmas sales, and continues to take the top end consumer items from the local store. On line shopping and personal shopping by car use two different modes of freight, and the economy could not support both. So the strip malls are hurting badly, and the Internet still provides methods to engage in very smart shopping, searching out the goods you need and pre-planning the shopping trip. We are undergoing an equilibrium shift, just like in the 20s. In the twenties, commercial radio instantly put a premium on the auto car over the street car. We had a depression because department stores, with a hundred dollars in equipment suddenly broadcast to all the drivers the goods in stock, and this suddenness then required the build out of suburbia. Same thing in the long depression, 1897 with the street car and the horse. Now, in 2008, the web and United Parcel Service vs the car. The rule is simple, information revolutions cause rapid changes in local transportation and a depression results. If we try and ramp up under the same transportation system, we ramp up both home delivery and personal shopping by car; the economy cannot support both, and home delivery is going to win the battle. To see how this works, look at Fresno, my home town. From 1920 to 1926 we built out this great streetcar system. By 1930 the street car tracks were torn out and the automobile won the day. \By the way, the CAPTCHA on this blog works badly for the casual, non-registered reader. For example, it wants me to type five-eights, as a numerical fraction, which my keyboard does not have.

Yes but . . .

Submitted by Trippp on Wed Apr. 22, 2009 3:05 PM PDT.
MarkH, By denial I mean the fact that people don't understand that the transition from cheap energy to more expensive (but renewable) energy means the world economy must slow down a significant amount. And when the world economy slows down to sustainable levels, what happens then? Nobody ever seems to even consider that question, much less answer it. Tripp

Oil and gas prices

Submitted by Anonymous (not verified) on Thu Apr. 23, 2009 1:58 AM PDT.
tagged as: 
I can look back over the past year and completely agree on a personal level. I still have a job, my husband still gets his SS check, but the price of oil last year (we live in NH and heat with oil and wood which went up in price too) plus the price of gas (we are rural and have no choice but cars) hit us very hard. We have not yet recovered from those costs, and I will not get my usual raise nor any bonuses this year. My bonuses only come when the firm as a whole makes enough money.

Oil prices and their general economic impact

Submitted by Rick B on Thu Apr. 23, 2009 9:41 PM PDT.
Just one other thing to consider. The biggest impact on the general economy comes from the price of fuel at the pump. But the price of fuel at the pump is a function of the supply of fuel from the refineries, not from the well-head. Unfortunately, the refiners have pretty much eliminated the direct connection from the well-head price of oil by simply reducing the amount of oil they refine when prices at the pump get too low. This was demonstrated when gasoline prices were at their highest by the large number of oil tankers floating off shore that simply were not brought in to provide more refined fuel. It ain't supply and demand any more, guys. Now it's supply from the well-head and demand from the consumer at the extremes but prices at the gas pump manipulated within those levels to go up to the level of customer tolerance by the refiners.

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