from Energy, Security, and Climate and Energy Security and Climate Change Program

Does Expensive Oil Inevitably Cause Recession?

October 06, 2011

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Fossil Fuels

Economics

Financial Markets

Economic Crises

There is a popular belief that once U.S. petroleum expenditures exceed some threshold, recession results. Writing at the Harvard Business Review blog, Chris Nelder and Gregor MacDonald present this position clearly:

 

“The connection between oil shocks and recessions has been understood for decades. We have ample historical evidence that when petroleum expenditures reach 5% of GDP, recession typically follows. Annual energy expenditures rose from 6.2% of U.S. GDP in 2002 to a painful 9.8% in 2008, which was immediately followed by an economic crash. And now oil is sending energy expenditures back above 9% of GDP, just as we see fresh indications that the recession persists. This is not a coincidence.”

 

Some variation on this theme is a consistent feature of both peak oil writings and more moderate warnings about the economic threats posed by expensive oil. Indeed it would not be an exaggeration to say that this sort of worry motivates a large slice of energy policy thinking.

 

If you scratch the surface, though, claims of a threshold beyond which the economy goes into recession turn out to be pretty shaky.

 

Let’s start with a basic theoretical point: There is no fundamental reason to believe that 5 percent (or anything similar) should be a magic number. Petroleum expenditures were equal to 4.5, 4.5, and 4.3 percent of GDP in 1970, 1971, and 1972 respectively. Does anyone really believe that the U.S. economy would have gone into recession had that spending been half a percentage point higher?

 

There’s also an empirical problem: there are many years – 1976, 1977, 1978, 1979, 1983, 1984, 1985, 2006 – in which petroleum expenditures have exceeded five percent that have not coincided with recessions.

 

In fact the five percent claim rests on only three data points: the two 1970s recessions and the 2007-2009 one.

 

There is a huge literature attempting to explain all three recessions. None of them, though, tend to be chalked up to high oil spending per se. What does appear to play a large role, particularly in the 1970s cases, is a rapid increase in oil costs that temporarily overwhelms the economy’s ability to adjust. The corollary, though, is that high oil costs reached through gradual increases probably won’t do the same sort of harm.

 

There is, however, a possible back door explanation for why high petroleum expenditures relative to GDP  seem to correlate with recessions even if they don’t do a good job explaining them: it is easier for petroleum expenditures to undergo big changes in short periods of time if they are starting from a high level. If, say, the price of oil rises 50% from a starting point where petroleum expenditures are 2% of GDP, the change in spending is 1% of GDP; in contrast, if the price of oil rises the same 50% from a starting point where petroleum expenditures are 6% of GDP, the change in spending is 3% of GDP. Whatever your transmission mechanism – supply side contraction, demand destruction, shifts in consumer preferences for durable goods – the 3% jump is going to be far more economically damaging than the 1% one. Indeed the years where oil spending was high but recession was absent generally come from a period where prices were fairly stable.

 

This is a subtle but important distinction from the oft asserted five percent rule. It suggests that while rising oil costs can lead to substantial economic harm, they do not necessarily need to.  Specifically, it points to the increasing importance of blunting both price volatility and its consequences so long as the world remains in expensive oil territory. Bob McNally and I discussed the volatility problem at some length in a recent Foreign Affairs essay. The compound danger of high and volatile oil prices makes focusing on remedies to that problem all the more important.

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