Oil Prices and the Economic Downturn
James D. Hamilton
Professor of Economics
for the Joint Economic Committee of the
Big increases in the price of oil that were associated with events such as the 1973-74 embargo by the Organization of Arab Petroleum Exporting Countries, the Iranian Revolution in 1978, the Iran-Iraq War in 1980, and the First Persian Gulf War in 1990 were each followed by global economic recessions.
The price of oil doubled between
June 2007 and June 2008, a bigger price increase than in any of those four
earlier episodes. In my mind, there is
no question that this latest surge in oil prices was an important factor that
contributed to the economic recession that began in the
Unlike those earlier episodes, in
which there had been a single dramatic development behind the oil price spike,
the price rise over 2007-08 resulted from a number of separate factors. World oil production decreased slightly
between 2005 and 2007. Declining
production from mature oil fields in the
Although production stagnated, the
demand for petroleum continued to boom.
World petroleum consumption had increased by 5 million barrels per day
during 2004 and 2005, driven largely by a 9.4% increase in global GDP over the
two years. Over the next two years--
2006 and 2007-- world GDP grew an additional 10.1%, which in the absence of an
increase in the price of oil would have produced further big increases in the
quantity of oil consumed. Even with the
price increases, Chinese oil consumption increased by 870,000 barrels per day
between 2005 and 2007. With no more oil
being produced, that meant that residents of the
How much the price needed to rise
in order to balance global demand with
supply depends on how quickly consumers change their habits in response
to a change in the price of oil. The
historical experience has been that even very large oil price increases cause
relatively little immediate change in the quantity of oil consumed. The
response of consumers to energy price increases over 2004-2006 was if anything
even smaller than those historical estimates.
One reason for that smaller response may be that energy expenditures as
a fraction of total spending by
By June of 2008, the price of gasoline had reached $4/gallon, driving the energy budget share back up to 7%. While some people had been ignoring $3 gasoline, $4 definitely got their attention. The resulting abrupt changes in spending patterns can be quite disruptive for certain key economic sectors and seem to be part of the mechanism by which the earlier oil price shocks had contributed to previous economic recessions. The kinds of economic responses we saw between 2007:Q4 and 2008:Q3 were in fact quite similar to those observed to have followed previous dramatic oil price increases.
One notable example was the plunge
in auto sales. The number of light
trucks sold (which includes the once-dominant SUV category) fell by 23% between 2007:Q2 and 2008:Q2. One indication that this sales decline was
caused by oil prices and not other economic developments is the observation
that sales of imported cars were up by 9% over this same period. Since the domestic manufacturers were more heavily
reliant on sales of the less fuel-efficient vehicles, these changes represented
a significant hit to the domestic auto sector.
Declining production of motor vehicles and parts alone subtracted half a
percent from total
More broadly, another pattern we observed in earlier oil price shocks was a deterioration in consumer sentiment and slowdown in overall consumer spending. Americans buy about 140 billion gallons of gasoline each year, meaning that a dollar per gallon increase in the price takes away $140 billion from their annual purchasing power. The declines in consumer sentiment and slowdown in consumer spending that we observed between 2007:Q4 and 2008:Q3 are very much in line with what we saw happen in response to historical energy price shocks of similar magnitude.
In 2003, I published a description
of the response of
I was quite surprised by that last
result, because of course there were other serious problems for the
There is also an interactive effect between the oil price shock and the problems in housing. Lost jobs and income were an important factor contributing to declines in home sales and prices, and we saw the biggest initial declines in house prices and increase in delinquencies in areas farthest from the urban core, suggesting an interaction between housing demand and commuting costs. Once house price declines and concomitant delinquencies reached a sufficient level, the solvency of key financial institutions came to be doubted. The resulting financial problems turned the mild recession we had been experiencing up until 2007:Q3 into a much more severe downturn in 2008:Q4 and 2009:Q1. Whether those financial problems were sufficiently insurmountable that we would have eventually arrived at the same crisis point even without the extra burden of the recession of 2007:Q4-2008:Q3 is a matter of conjecture. But that oil prices made an important contribution both to the initial downturn as well to the magnitude of the problems we’re currently facing seems to me to be indisputable.
Could anything have been done to
prevent this? The decision by the
Federal Reserve to drop interest rates so quickly in the first few months of
2008 likely contributed to some of the commodity price speculation. In the spring of 2008 I had further
recommended some temporary sales of oil out of the Strategic Petroleum Reserve
as another measure that might have proven beneficial. There is also a tradeoff between our goals of
environmental protection and reducing
But although there are some concrete steps that might have helped, it would be a mistake to focus exclusively on short-term gimmicks. The fundamental problem that I have highlighted above-- booming world petroleum demand in the face of stagnant world oil production-- is very much a long-run challenge. The reality is that no policy could have prevented a substantial increase in the price of oil between 2005 and the first part of 2008. The main lesson that I hope we draw from this experience is that this long-run challenge is something with very real and present short-run consequences.
Will the recent uptick in oil
prices undermine prospects for recovery from the recession? Retail gasoline prices have risen about 50
cents a gallon from their low in December.
That takes away about $70 billion from consumers’ annual spending power,
which is hardly helpful for the broader challenge of restoring household
balance sheets to a level where spending could be expected to pick back
up. But let me emphasize that although I
believe that the initial spike in oil prices was an important element of the
process that produced our current difficulties, we are currently at a point at
which the multipliers and spillovers associated with the recession dynamic
itself have become far more important factors than the price of oil. The problems faced by
Notwithstanding, the recent rise in oil prices again underscores the present reality of the long-run challenges. Even if we see significant short-run gains in global oil production capabilities, if demand from China and elsewhere returns to its previous rate of growth, it will not be too long before the same calculus that produced the oil price spike of 2007-08 will be back to haunt us again.