Thursday, May 21, 2009

Oil Prices and Recession

I think in all of our chewing on the causes of the current economic crisis, one thing has been somewhat overlooked: the effect of higher oil prices in 2008. Professor James Hamilton, in testimony to Congress, made this point recently:

I'm persuaded that the oil price surge over 2007-08 was also an important
factor that contributed to the economic recession that began in 2007:Q4.
My testimony focuses on the causes and economic consequences of the big run-up
in oil prices that we saw in 2007-08. There was a modest drop in global
petroleum production between 2005 and 2008, caused in part by declining
production from mature fields in the North Sea and Mexico and a big drop in
Saudi Arabian oil production. But despite stagnant production, world petroleum
demand continued to boom. World GDP increased by 10.1 percent over these two
years, and Chinese consumption of oil increased by almost a million barrels per
day. The price of oil had to rise by whatever it took to persuade the rest of us
to decrease oil consumption, despite the strong growth in world income.

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. It was not until
the price rose substantially over $3 a gallon that we began to see some
significant changes on the part of American consumers. Unfortunately, those
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. As I note in my
testimony, 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.

The recessionary impact of higher oil prices is something to keep in mind, given the fact that higher demand and lower supply will be probably be a recurring experience in the coming years, with multiple effects on the economy, standard of living, and the American lifestyle.

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