Oil and the Economy

Will higher prices mean a recession?

Economists tend to start biting their nails when they see the price
of oil start to rise. One way to remember the timing of recessions in the
US economy over the past 30 years is to think back to what are called “oil
shocks” – a steep rise in oil prices. The most substantial shocks occurred
in 1973-74, 1979-80, and 1991, and roughly correspond to the post-1970
recessions.

Since the price of oil has recently risen to over 30$ a barrel, a natural
question to ask is if another recession is in the pipeline.

The first shock occurred at about the time of a long-run slowdown in
productivity in the U.S. and much of the western world. The second shock
came just before the severe recession in the early 80’s, and the final
short-lived shock in 1991 occurred at about the same time as the short-lived
1991 recession.

Some economists are arguing that it may already be too late, the seeds
of recession have already been sown. (For example, see A. Oswald’s article
(.pdf).)

 

Recession dates 1970- (NBER):  November 1973 – March 1975 January 1980 – July 1980 July 1981 – November 1982 July 1990 – March 1991

Some data

Let’s first look at the historical experience. The graph below looks
at the behavior of oil prices and GDP growth over the past 40 years. While
the relation is far from perfect, it does look as if rising oil prices
may tend to lead to low real GDP growth, especially in the recession years
as noted above.

A better way to examine this data is to look at a cross-plot of GDP
growth versus the change in oil prices. The following graph looks at such
a graph using Real GDP growth (vertical axis) and the percent change in
oil prices (horizontal axis) from the prior year – since it takes some
time for oil prices to fully impact the economy. The graph also contains
a regression line which shows the relation between prices and output (standard
deviation in parenthesis):

GDP Growth	=	3.573	–	0.0474	D(price oil)
		(0.311)		(0.0148)

Interpretation

Given the fitted line, we see that a 10% increase in the price of oil
would correspond to a substantial (and significant) 1/2 percentage point
reduction in GDP growth.  Of course, I would like to warn everyone
that these results are merely suggestive and in no way come even close
to a full and careful econometric analysis – do not use this number as
a serious quantitative measure of the effect of oil prices on the economy!

We would have to, at the very least, include in our analysis other factors
that may impact GDP growth as well as to fully model the dynamics and allow
for non-linear effects. Also, the above data is only annual. See papers
by A.
Oswald and J. Hamilton
for more careful analyses.

The above analysis has also assumed that there is a causal relationship
running from energy price increases to output declines. However, we might
have the causality reversed. Growth tends to increase demand for energy,
and hence higher GDP growth may push up oil prices. There may also be a
“political economy” component, since the price of oil is affected by the
production decisions of the OPEC countries and these OPEC countries may
time their price increases in reaction to world economic conditions – thus
complicating attempts to measure the effect of oil prices.

Recession? Not necessarily…

While there has perhaps been a relation between rising prices and GDP
growth, we may not have to worry as much as in the past. Oil costs have
been a shrinking part of the US economy in recent years. Since 1970, energy
use as a faction of GDP has fallen by around 35%. (See
graph)

If indeed the link between macroeconomy and oil prices were to weaken
– it would be rather fitting: as soon as we seem to understand a macroeconomic
relation, it tends to go away.

More Economics Features

Will
oil end the boom? Post in the Forum.

Links From the Web

GDP Data

Oil Data – Monthly
Energy Review from the Department of
Energy.

Energy
Outlook Annual

A.
Oswald’s home page

J. Hamilton home page

Filed under: Economy