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

Will High Oil Prices Crush the U.S. Economy?

February 24, 2012

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Rising gasoline prices have a way of bringing out the hidden energy pundit in all of us. Most speculation tends to focus on why oil prices might be rising and on how high they might go. But a second strand of questioning is probably even more important: What do rising prices mean for the world? There’s a lot of wisdom that’s accumulated over the past few decades in attempts to answer that question. But I have to wonder whether there aren’t some fundamental changes that might render a lot of it obsolete.

It’s always been difficult to pin down the economic impact of high oil prices for one simple reason: high prices and high economic growth tend to go hand in hand. Strong economies drive rising oil demand which in turn raises gasoline prices; even if that shaves off a bit of economic growth, the net outcome still looks positive. Think of it like wind resistance in a foot race: it slows you down, but it probably isn’t going to send you heading backwards.

One of the main ways that economists have tried to cut through this complication is by distinguishing between high oil prices that result from demand spikes and ones that follow supply cuts. Demand driven oil shocks should be relatively benign. Supply driven ones, in contrast, should be far more devastating. For many observers, that explains why the 1970s oil shocks were so damaging, and why many subsequent ones were far less severe.

I suspect, though, that something has changed in the world economy to throw a wrench in all of this. We now live in a world where U.S. economic health doesn’t drive global oil demand and prices the same way that it used to. Once upon a time, if the U.S. economy was flagging, the only way to generate a oil big price increase was to have a supply shock. That meant that oil spikes were rare in periods where the U.S. economy was shaky; for the most part, oil shocks hit when the U.S. economy was relatively strong, probably blunting their effects.

But we now live in a multispeed world. Western economies can be on their knees, but oil demand can still be on the upswing due to healthy growth in China, India, and other emerging economies (not least those that also export oil). It’s become far more likely that we’ll have price spikes during periods where the U.S. economy is already weak. That makes historical precedent harder to go by.

There’s another way to think about this. I mentioned that economists like to split oil spikes into ones driven by low supply and ones spurred by high demand. Casual analysis would put a price spike driven by economic growth in the developing world in the latter category. But what seems like a demand shock if you’re sitting in Shanghai looks a lot more like a supply shock if you live in San Francisco. Surging demand in the developing world takes barrels off the market in the same way that falling production in Iraq or Nigeria would. My guess is that these new “demand” shocks will hit the U.S. economy much more like supply shocks have in the past.

That’s bad news. So is there anything the United States can do beyond getting its energy policy right? I’ll throw one idea out there: it could work on boosting export relationships with those countries that are driving economic growth. If an economic boom in the developing world rasies oil prices, and that slows the U.S. economy down, strong export relationships with the sources of that growth will tend to provide a countercyclical balance. There’s some evidence that Japan benefits from a similar sort of arrangement with oil exporters: the Japanese current account balance tends to improve, rather than weaken, when oil prices jump. Perhaps the United States could ultimately do the same?

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